Financial Instruments
SLIDES PREPARED AND PRESENTED BY
NELSON PANDE
Lecture Objectives…..
By the end of this session you should be able to:
Define financial instruments in terms of financial
assets and financial liabilities
Indicate how financial instruments should be
measured and how gains and losses should be treated
Distinguish between debt and equity capital
Apply the requirements of relevant accounting
standards to the issue and finance costs of:
equity, redeemable preference shares and debt with no
conversion rights and convertible debt
Answer Exam type questions relating to these areas.
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Financial instrument
A contract that gives rise to a financial asset of one
entity and a financial liability or equity instrument
of another.
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Financial
FinancialLiability Equity
Asset Instrument
Financial
Instrume
nts
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Cash or an equity
instrument of another
entity
Financial Asset
A contractual right to
receive cash or another
financial asset
A contractual right to
exchange financial assets
or liabilities on favourable
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Financial Liability
Any liability that is a contractual obligation:
to deliver cash or another financial asset
to exchange financial assets or liabilities with
another entity on unfavourable terms
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Equity instrument
Any contract that evidences a residual interest in
the assets of an entity after deducting all of its
liabilities.
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Compound Instruments
Any instrument that has characteristics of both an
equity instrument and a financial Liability.
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•Financial instruments
PRESENT should be presented
according to their
ATION substance, not merely
their legal form
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Show in the SOFP Show in the SOFP Show under Split into debt and
under Non or under Non or equity & disclose
Current Assets Current Liabilities Equity in the SOFP accordingly
Financial Financial Equity Compound
Asset Liability Instrument Instrument
Financial
Instruments
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Financial Liabilities
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Initial Recognition
Measure at its fair value. (being the cash received,
less any issue costs associated with issuing the
liability).
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Subsequent Measurement
Measure all financial liabilities at amortised cost
except (liabilities held for trading which are
measured at FVTPL)
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AMORTISED COST
Reporting Opening Interest Cash Closing Amount
Period Amount (using (The Amortized
effective Cost)
rate of
interest)
Year Ended 31
December 20X1
X X (X) X
• In the first year of the liability, the initial value will be its
fair value less transaction costs.
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Example
On 1 January 20X5 a 5% loan note is issued for
$5,000. The loan is redeemable after three years at
a premium of $487, giving an effective rate of
interest of 8%. Interest is paid annually in arrears.
Required:
Show how the value of the loan note changes over
its life.
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Practice Question
An entity issues 4% loan notes with a nominal value of
$20,000. The loan notes are issued at a discount of 2.5%
and $534 of issue costs are incurred. The loan notes will
be repayable at a premium of 10% after 5 years. The
effective rate of interest is 7%. Interest is payable
annually in arrears.
1. What amount will be recorded as a financial liability
when the loan notes are issued?
2. What amounts will be shown in the statement of profit
or loss and statement of financial position for year 1?
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Compound
instruments
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A compound instrument is one
that has characteristics of both a
financial liability and equity.
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An issue of a bond or loan that allows the
holders the choice of redemption in the
form of cash or a fixed number of equity
shares.
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IAS 32
IAS 32 specifies that compound instruments must
be split into:
a liability component (the obligation to repay cash)
an equity component (the obligation to issue a
fixed number of shares).
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Split accounting
Liability Component
Equity Component
is the present value of the cash repayments
Discounted using the market rate for non-convertible bonds the difference between the
cash received and the liability
component at the issue date.
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•Debt measured
at amortised
Subsequent cost
Measurement •Equity remains
unchanged
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EXAMPLE COMPOUND
INSTRUMENT
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Kitana issues 3,000 convertible bonds at the start of
2010. 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 $3,000,000. 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 300 ordinary shares. When the bonds are issued,
the prevailing market interest rate for similar debt
without conversion options is 9%.
Required
Show how these bonds should be accounted for in the
financial statements at 31 December
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PRACTICE QUESTION
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A company issues $20m of 4% convertible loan
notes at par on 1 January 2009. The loan notes are
redeemable for cash or convertible into equity
shares on the basis of 20 shares per $100 of debt
at the option of the loan note holder on 31
December 2011. Similar but non-convertible loan
notes carry an interest rate of 9%.
Required
Show how these loan notes should be accounted
for in the financial statements at 31 December
2009
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Financial Assets
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Financial Assets
Equity Investments Debt Investments
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Recognition
Recognise when, and only when, the entity
becomes party to the contractual provisions of the
instrument.
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Initial Measurement
At initial recognition, all financial assets are
measured at fair value.
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EQUITY INVESTMENTS
Fair Value through PL
Fair Value through OCI
Transaction costs are expensed
Transaction costs are
capitalised
Any gains and losses recognised directly in profit or loss
Any gains or losses
recognised through OCI
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DEBT INVESTMENTS
Measured at Amortised cost Measured at FVPL Measured at FVOCI
Initially measure at
FV plus costs.
Initially measure at
Interest income
Initially measure at FV
recognised at the
FV plus costs. Costs W/O to SOPL
effective rate as per
Interest income Revalue at each
amortised cost
recognised at the reporting date with
Revalue at each
effective rate gains or losses
reporting date with
recognised in PL
gains or losses
recognised in OCI
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Examination Type
Questions
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An 8% $30 million convertible loan note was issued on 1 April 20X5 at par. Interest
is payable in arrears on 31 March each year. The loan note is redeemable at par on
31 March 20X8 or convertible into equity shares at the option of the loan note
holders on the basis of 30 shares for each $100 of loan. A similar instrument
without the conversion option would have an interest rate of 10% per annum.
The present values of $1 receivable at the end of each year based on discount
rates of 8% and 10% are:
8% 10%
End of year
1 0.93 0.91
2 0.86 0.83
3 0.79 0.75
What amount will be credited to equity on 1 April 20X5 in respect of this financial
instrument?
A $5,976,000
B $1,524,000
C $324,000
D $9,000,000
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A 5% loan note was issued on 1 April 20X0 at its face
value of $20 million. Direct costs of the issue were
$500,000. The loan note will be redeemed on 31
March 20X3 at a substantial premium. The effective
interest rate applicable is 10% per annum.
At what amount will the loan note appear in the
statement of financial position as at 31 March 20X2?
A $21,000,000
B $20,450,000
C $22,100,000
D $21,495,000
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Dexon's draft statement of financial position as at 31
March 20X8 shows financial assets at fair value through
profit or loss with a carrying amount of $12.5 million as
at 1 April 20X7. These financial assets are held in a fund
whose value changes directly in proportion to a
specified market index. At 1 April 20X7 the relevant
index was 1,200 and at 31 March 20X8 it was 1,296.
What amount of gain or loss should be recognised at 31
March 20X8 in respect of these assets?
A $1,000,000 gain
B $96,000 gain
C $1,000,000 loss
D $96,000 loss
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Which of the following are not classified as financial
instruments under IAS 32 Financial Instruments:
Presentation?
A Share options
B Intangible assets
C Trade receivables
D Redeemable preference shares
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A company invests $5,000 in 10% loan notes. The
loan notes are repayable at a premium after 3
years. The effective rate of interest is 12%. The
company intends to collect the contractual cash
flows which consist solely of repayments of
interest and capital and have therefore chosen to
record the financial asset at amortised cost.
What amounts will be shown in the statement of
profit or loss and statement of financial position
for the financial asset for years 1–2?
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