(IFRS®) 9 Financial Instruments is a complex standard

1. Financial assets
2. Financial liabilities
3. Convertibles
1.  Financial assets
There are two types of financial asset (equity and debt instruments), which can be further split
into different categories.
(a) Equity investments

Equity instruments are likely to be shares that have been purchased in a company, but not
enough to give the investee significant influence (associate), control (subsidiary) or joint control
(joint venture).
There are two options here, depending on the intention of the entity. The default category is
fair value through profit or loss (FVTPL).
Equity instruments: fair value through profit or loss (FVTPL)

FVPL is  the default treatment for equity investments where transaction costs such as broker
fees are expensed and not capitalised within the initial cost of the asset. Subsequently, the
investment is revalued to fair value at each year end, with the gain or loss being taken to the
statement of profit or loss.
Alternatively, equity instruments can be classified as fair value through other comprehensive
income (FVOCI). It is important to note that this designation must be made on acquisition and
the equity investments cannot retrospectively be treated as FVTPL. This is only an option if the
equity investment is intended to be a long-term investment.
Equity instruments: fair value through other comprehensive income (FVOCI)

Using FVOCI, the alternative treatment, transaction costs can be capitalised as part of the initial
cost of the investment. Similar to FVTPL, the instrument would then be revalued to fair value at
the year end. The big difference is where the gain or loss is recorded. In FVOCI, the gain or loss
is recognised within Other Comprehensive Income and held in an investment reserve. In this
way it is similar to the accounting for PPE revaluation model. However unlike the treatment for
a revaluation surplus, there can be a negative FVOCI reserve.
When the FVTOCI instrument is sold, the reserve can be left in equity, or transferred into
retained earnings.
(b) Debt instruments
These are usually bonds or loan notes, or other instruments which are likely to carry interest
and a capital element of repayment. The treatment of the debt instrument depends on the
intention of the entity, and there are three options for categorising debt instruments.
Debt instruments: fair value through other profit or loss (FVPL)

The default category is FVPL, but this is rare within ACCA exams and it is much more common
to apply one of the two alternative treatments, being amortised cost or FVOCI.
Debt instruments: amortised cost

To apply this treatment, the instrument must pass two tests; first the business model test and
secondly the contractual cash flow characteristics test.

 Business model test – the entity must intend to hold the instrument in order to collect
the interest payments and receive repayment on maturity.

 Contractual cash flow characteristics test – the contractual terms give rise to cash flows
which are solely repayments of the interest and principle amount.
In the FR exam, it will only be the first test which may (or may not) be met, so management
must decide on their intention for holding the debt instrument. This treatment tends to be the
most common in exam scenarios, as it allows the examiner to test the principles of amortised
cost accounting.
The principles of amortised cost accounting require that interest must be recorded on the
amount outstanding. For example, on a $10m 5% loan, with $10m repayable at the end of a
three-year term, interest would simply be recorded as $500,000 a year.
The issues arise when the balance may be repaid at a premium. For example, the terms of the
$10m loan, issued on 1 January 20X1, may be that the holder receives interest of 5% a year, but
then receives $11m back at the end of the three year term, on 31 December 20X3. This means
that the holder is now earning interest in two different ways. Firstly, they are earning the 5%
payment each year. Secondly, they are earning another $1m interest over three years in the
form of receiving more money back than they invested.

IFRS 9, Financial Instruments, requires that a constant rate of interest is applied to this
balance to better reflect the reality of the situation. This rate takes into account both the
annual payment and the premium payable on redemption. In the FR exam, this rate will be
provided in the question. The question will provide information about the effective rate of
interest. Let’s say that in this example, the effective rate of interest is 8.08%. This rate is applied
to the outstanding balance each year in order to calculate the interest earned on the
investment, which is the amount to be recorded in investment income in the statement of
profit or loss.
The easiest way to do this is often to use a table showing the movement of the asset.

The figures in the interest column would be the amounts recorded as investment income in the
statement of profit or loss each year. This is increasing to reflect the fact that the amount
owed is increasing as it gets closer to redemption.
The balance in the final column reflects the amount owed to the entity at each year end, and
shows how the balance outstanding increases from $10m to $11m over the three year period.
The double entries for the asset in year one would be as follows:

 1 January 20X1 – The $10m loan is given to the third party. This reduces the entity’s
cash balance, but creates a long-term receivable of $10m, meaning the entry is Dr
Receivable $10m, Cr Cash $10m.
 The interest then accrues over the year at the effective rate of 8.09%. This increases the
amount of the receivable and is recorded in investment income, so the entry is Dr
Receivable $808k, Cr Investment income $808k.
 31 December 20X1 – The entity receives a payment of $500,000, being 5% of the
original $10m loaned. This figure will be the same each year. This reduces the value
owed to the entity, so the entry is Dr Cash $500k, Cr Receivable $500k.
  The result of these entries is that the entity has a closing receivable of $10.308m. This
will all be held as a non-current asset, as the amount is not receivable until 31
December 20X3.
 This would carry on for the next two years, until the full amount is repaid at 31
December 20X3 with the entry Dr Cash $11m, Cr Receivable $11m.
The total interest to be recorded in the statement of profit or loss over the three years is
$2.5m, being the $808k + $833k + $859k. This $2.5m represents all the interest earned by the
entity over the three years. This consists of the $1.5m annual payments ($500k a year), and
the additional $1m received (the difference between loaning the $10m and receiving the
$11m).
Debt instruments: fair value through other comprehensive income (FVOCI)

The final possible treatment for a debt instrument is to hold it at fair value through other
comprehensive income (FVOCI). Similar to holding the instrument at amortised cost, two tests
must be passed in order to hold a debt instrument in this manner.

 Business model test – the entity intends to hold the instrument in order to collect the
interest payments and receive repayment on maturity, but may sell the asset if the
possibility of buying one with a greater return arises.

 Contractual cash flow characteristics test – the contractual terms give rise to cash flows
which are solely repayments of the interest and principle amount.
Again, it is only the first of these that candidates will need to consider in the FR exam,
highlighting that the choice of category will depend on the intention of management.
If the entity chooses to hold the debt instrument under the FVOCI or FVTPL category, they will
still produce the amortised cost table as above, taking the same figure to investment income.
At the year end, the asset would then be revalued to fair value, with the gain or loss being
recorded in either the statement of profit or loss if classed as FVTPL or in other
comprehensive income OCI if classified as FVOCI.
2. Financial liabilities
In the FR exam, financial liabilities will be held at amortised cost. These will be similar to the
treatment shown earlier for assets held under amortised cost. Instead of having investment
income and an asset, there will be a finance cost and a liability. The major difference in the
accounting treatment relates to the initial treatment upon issue of the financial liability. Initially
these are recognised at NET PROCEEDS, being the cash received net of any issue costs.
Therefore if an entity looks to raise $10m of funding, but pays a broker $200,000 for raising the
finance, the initial double entry is to Dr Cash $9.8m and Cr Liability with the $9.8m. Taking the
$200,000 immediately to the statement of profit or loss is incorrect because this fee must be
spread over the life of the instrument. This is effectively done by applying the effective interest
rate to the outstanding liability.
Here, the effective interest rate on the liability now incorporates up to three elements. It would
incorporate the annual interest payable, any premium repayable on redemption, and any
issue costs. This is shown in the example below.

EXAMPLE
Oviedo Co issued $10m 5% loan notes on 1 January 20X1, incurring $200,000 issue costs. These
loan notes are repayable at a premium of $1m on 31 December 20X3, giving them an effective
interest rate of 8.85%.
In the above example, the 5% relates to the coupon rate, which is the amount required as an
annual payment each year. This is always based on the face (par) value of the instrument, so
means that $500,000 will be payable annually (being 5% of $10m).
As seen in the earlier example relating to financial assets held at amortised cost, the effective
interest rate will be applied to the outstanding balance in each period. Again, a table is the
easiest way to calculate this, as shown below.
 

The entries in 20X1 will be as follows:

1 January 20X1 – The loan is issued, meaning that Oviedo Co receives $9.8m, being the $10m
less the issue costs. Therefore the entries are
Dr Cash $9.8m, Cr Liability $9.8m.
Over the year, interest on the liability is accrued at the effective interest rate of 8.85%,
Dr Finance cost $867k, Cr Liability $867k.
31 December 20X1 – The payment of $500k is made, giving the entry
Dr Liability $500k, Cr Cash $500k.
This leaves a closing liability of $10.167m. This will all be sat as a non-current liability, as none
of it will be repayable until 31 December 20X3.
If we look at the interest column, we will see that the total interest paid is $2.7m ($867k +
$900k + $933k). This is the total which will be expensed to the statement of profit or loss over
the three year period. This amount consists of three elements:

 $1.5m in annual payments ($500k a year)

 $1m premium repaid (issued $10m loan, but repaid $11m)

 $200k issue costs

As we can see, the issue costs have been expensed over three years, rather than being
expensed immediately in 20X1.
3. Convertibles
Convertible instruments are instruments which give the holder the right to either demand
repayment of the principle amount or to write off the debt and instead convert the balance into
shares. In the FR exam, you will only have to deal with convertible instruments from the
perspective of the issuer, being the person who has received the cash.
Convertible instruments could ultimately result in the issue of shares or the repayment of the
loan, but the choice will be in the hand of the holder. As we do not know whether the holder
will choose to receive the cash or convert the instrument into shares, we must reflect an
element of both within the financial statements. Therefore these are accounted for initially
using split accounting, splitting it into the equity and liability components.
The liability component is the first thing to calculate. We work this out by calculating the
present value of the payments at the market rate of interest (using the interest on an
equivalent bond without the conversion option). The discount rates required to do this will be
given to you in the exam.
In reality the market rate of interest will be higher than the coupon rate, being the annual
amount payable to the holder of the loan. This is because the holder of the loan is willing to
accept a lower rate of annual interest compared to the market, in exchange for the option to
convert the loan into shares.
Once the liability component has been calculated, the equity component is then worked out.
This is simply a balancing figure, and represents the difference between the cash received and
the liability component.
EXAMPLE
Oviedo Co issued $10m 5% convertible loan notes on 1 January 20X1. These will either be
repaid at par on 31 December 20X3, or converted into shares on that date. Equivalent loan
notes without the conversion carry an interest rate of 8%. Relevant discount rates are shown
below.

It is important to note that the 5% discount rates are a red herring . It is the discount rates for
the market rate of interest that are important, i.e. 8%. The only thing we need the 5% for is to
work out the annual payment. As these are $10m 5% loan notes, this simply means that Oviedo
Co will need to make an annual payment of $500k in relation to these.
Therefore we can work out the value that the market would place on these loan notes by
looking at the present value of all the payments, discounted at the market rate of interest. If
this is a normal loan, ignoring the conversion, Oviedo Co would pay $500k in years 20X1 to
20X3, and then make a final repayment of $10m on 31 December 20X3.
As the market rate of interest is 8%, the present value of these payments can be calculated.
These are calculated in the table below.
 
The present value of all of the payments can be seen as $9.229m. This means that Oviedo Co
received $10m, but the present value of the payments to be made have an initial value of only
$9.229m. As a result, the holders of the loan notes are effectively losing $771k compared to if
they had simply given Oviedo Co a normal loan at the market rate of interest.
This $771k is the amount of interest the holders are willing to lose in order to have the option
to convert the loan into shares. This is taken as the initial value of the equity element.
On 1 January 20X1, the double entry to record the transaction in the records of Oviedo Co are
as follows:
Dr Cash $10m – reflecting the full cash received from the issue of the convertibles.

 Cr Liability $9.229m – reflecting the present value of the liability on 1 January 20X1

 Cr Equity $0.771m – reflecting the value of the equity component.

The equity balance would be held as ‘convertible options’ within other components of equity.
Subsequently, this equity amount remains fixed until conversion, but the liability must be
held at amortised cost. This must be built back up to $10m over the next 3 years, to reflect the
amount which the holder would require if they demand repayment rather than conversion of
the loan notes.
As with the financial liability noted earlier, the interest column is taken to the statement of
profit or loss each year as a finance cost.
At the end of the three years, Oviedo Co will either repay the $10m liability, or this will be
turned into shares, with the $10m balance and the option balance of $771k transferred to
share capital and share premium.
To perform well at FR, it is essential that candidates are able to identify the potential
treatments for financial assets, produce amortised cost calculations and understand the
accounting entries required for a convertible instrument
Let us start by looking at the definition of a financial instrument, a financial instrument is a
contract that gives rise to a financial asset of one entity and a financial liability or equity
instrument of an other entity.

For example, when an invoice is issued on the sale of goods on credit, the entity that has sold
the goods has a financial asset – the receivable – while the buyer has to account for a financial
liability – the payable.
Another example is when an entity raises finance by issuing equity shares. The entity that
subscribes to the shares has a financial asset – an investment – while the issuer of the shares
who raised finance has to account for an equity instrument – equity share capital.
A third example is when an entity raises finance by issuing bonds (debentures). The entity that
subscribes to the bonds – ie lends the money – has a financial asset – an investment – while
the issuer of the bonds – ie the borrower who has raised the finance – has to account for the
bonds as a financial liability.

In simple terms what we are really talking about is how we account for investments in shares,
investments in bonds and receivables (financial assets), how we account for trade payables and
long-term loans (financial liabilities) and how we account for equity share capital (equity
instruments).
(Note: financial instruments do also include derivatives, but this will not be discussed in this
article.)

In considering the rules as to how to account for financial instruments there are various issues
around classification, initial measurement and subsequent measurement. This article will
consider the accounting for equity instruments and financial liabilities. Both arise when the
entity raises finance – ie receives cash in return for issuing a financial instrument. A subsequent
article will consider the accounting for financial assets.
Distinguishing between debt and equity
For an entity that is raising finance it is important that the instrument is correctly classified as
either a financial liability (debt) or an equity instrument (shares). This is important as it will
directly affect the calculation of the gearing ratio, a key measure that the users of the financial
statements use to assess the financial risk of the entity. This will also impact on the
measurement of profit as the finance costs associated with financial liabilities will be charged to
the statement of profit or loss, thus reducing the reported profit of the entity, while the
dividends paid on equity shares are an appropriation of profit rather than an expense. When
raising finance the instrument issued will be a financial liability, as opposed to being an equity
instrument, where it contains an obligation to repay.
Thus, the issue of a bond (debenture) creates a financial liability as the monies received will
have to be repaid, while the issue of ordinary shares will create an equity instrument. In a
formal sense an equity instrument is any contract that evidences a residual interest in the
assets of an entity after deducting all of its liabilities. It is possible that a single instrument is
issued that contains both debt and equity elements. An example of this is a convertible bond –
ie where the bond contains an option to convert to shares rather than be repaid in cash. The
accounting for this compound financial instrument will be considered in a subsequent article.

Equity instruments
Equity instruments are initially measured at fair value less any issue costs. In many legal
jurisdictions when equity shares are issued they are recorded at a nominal value, with the
excess consideration received recorded in a share premium account and the issue costs being
written off against the share premium.

Example 1: Accounting for the issue of equity

Dravid issues 10,000 $1 ordinary shares for cash consideration of $2.50 each. Issue costs are
$1,000.

Required
Explain and illustrate how the issue of shares is accounted for in the financial statements of
Dravid.

Solution
The entity has raised finance (received cash) by issuing financial instruments. Ordinary shares
have been issued, thus the entity has no obligation to repay the monies received; rather it has
increased the ownership interest in its net assets. As such, the issue of ordinary share capital
creates equity instruments. The issue costs are written off against share premium. The issue of
ordinary shares can thus be summed up in the following journal entry.
  Equity instruments are not remeasured. Any change in the fair value of the shares is
not recognised by the entity, as the gain or loss is experienced by the investor, the
owner of the shares.
 Equity dividends are paid at the discretion of the entity and are accounted for as
reduction in the retained earnings, so have no effect on the carrying value of the
equity instruments.

 If the shares issued were redeemable, then the shares would be classified as financial
liabilities (debt) as the issuer would be obliged to repay back the monies at some stage
in the future.
Financial liabilities
A financial instrument will be a financial liability, where it contains an obligation to repay.
Financial liabilities are then classified and accounted for as either fair value through profit or
loss (FVTPL) or at amortised cost.
Financial liabilities at amortised cost
The default position is, and the majority of financial liabilities are, classified and accounted for
at amortised cost. Financial liabilities that are classified as amortised cost are initially measured
at fair value minus any transaction costs. Accounting for a financial liability at amortised cost
means that the liability's effective rate of interest is charged as a finance cost to the statement
of profit or loss (not the interest paid in cash) Changes in market rates of interest are ignored
– ie the liability is not revalued at the reporting date. This means that each year the liability
will increase with the finance cost charged to the statement of profit or loss and decrease by
the cash repaid.

Example 2: Accounting for a financial liability at amortised cost

Laxman raises finance by issuing zero coupon bonds at par on the first day of the current
accounting period with a nominal value of $10,000. The bonds will be redeemed after two years
at a premium of $1,449. The effective rate of interest is 7%.
Required
Explain and illustrate how the loan is accounted for in the financial statements of Laxman.

Solution
Laxman is receiving cash that it is obliged to repay, so this financial instrument is classified as a
financial liability. There is no suggestion that the liability is being held for trading purposes nor
that the option to have it classified as FVTPL has been made, so the liability will be classified
and accounted for at amortised cost and initially measured at fair value less the transaction
costs. The bonds are being issued at par, so there is neither a premium nor discount on issue.
Thus Laxman initially receives $10,000. There are no transaction costs and, if there were, they
would be deducted. Thus, the liability is initially recognised at $10,000.

In applying amortised cost, the finance cost to be charged to the statement of profit or loss is
calculated by applying the effective rate of interest (7%) to the opening balance of the liability
each year. The finance cost will increase the liability. The bond is a zero coupon bond meaning
that no actual interest is paid during the period of the bond. Even though no interest is paid
there will still be a finance cost in borrowing this money. The premium paid on redemption of
$1,449 represents the finance cost. The finance cost is recognised as an expense in the
statement of profit or loss over the period of the loan. It would be inappropriate to spread the
cost evenly as this would be ignoring the compound nature of finance costs, thus the effective
rate of interest is given. In the final year there is a single cash payment that wholly discharges
the obligation. The workings for the liability being accounted for at amortised cost can be
summarised and presented as follows.

Example 3: Accounting for a financial liability at amortised cost

Broad raises finance by issuing $20,000 6% four-year loan notes on the first day of the current
accounting period. The loan notes are issued at a discount of 10%, and will be redeemed after
three years at a premium of $1,015. The effective rate of interest is 12%. The issue costs were
$1,000.

Required
Explain and illustrate how the loan is accounted for in the financial statements of Broad.

Solution
Broad is receiving cash that is obliged to repay, so this financial instrument is classified as a
financial liability. Again, as is perfectly normal, the liability will be classified and accounted for
at amortised cost and, thus, initially measured at the fair value of consideration received less
the transaction costs.

With both a discount on issue and transaction costs, the first step is to calculate the initial
measurement of the liability.

In applying amortised cost, the finance cost to be charged to the statement of profit or loss is
calculated by applying the effective rate of interest (in this example 12%) to the opening
balance of the liability each year. The finance cost will increase the liability. The actual cash is
paid at the end of the reporting period and is calculated by applying the coupon rate (in this
example 6%) to the nominal value of the liability (in this example $20,000). The annual cash
payment of $1,200 (6% x $20,000 = $1,200) will reduce the liability. In the final year there is an
additional cash payment of $21,015 (the nominal value of $20,000 plus the premium of
$1,015), which extinguishes the remaining balance of the liability. The workings for the liability
being accounted for at amortised cost can be summarised and presented as follows.
Because the cash paid each year is less than the finance cost, each year the outstanding liability
grows and for this reason the finance cost increases year on year as well. The total finance cost
charged to income over the period of the loan comprises not only the interest paid, but also the
discount on the issue, the premium on redemption and the transaction costs.
Financial liabilities at FVTPL

 Financial liabilities are only classified as FVTPL if they are held for trading or the entity
so chooses. This is unusual and only examinable in Paper P2. The option to designate a
financial liability as measured at FVTPL will be made if it significantly reduces an
‘accounting mismatch’ that would otherwise arise from measuring assets or liabilities or
recognising the gains and losses on them on different bases, or if the liability is part or a
group of financial liabilities or financial assets and financial liabilities that is managed
and its performance is evaluated on a fair value basis, in accordance with an investment
strategy.
 In addition, a financial liability may still be designated as measured at FVTPL when it
contains one or more embedded derivatives that would require separation. Financial
liabilities that are classified as FVTPL are initially measured at fair value and any
transaction costs are immediately written off to the statement of profit or loss.
 By accounting for a financial liability at FVTPL, the financial liability is also increased by a
finance cost and reduced by cash repaid but is then revalued at each reporting date with
any gains and losses immediately recognised in the statement of profit or loss. The
measurement of the new fair value at the year end will be its market value or, the
present value of the future cash flows, using the current market interest rates. The
interest rate used subsequently to calculate the finance cost will be this new current
rate until the next revaluation.
Example 4: Accounting for a financial liability at FVTPL

On 1 January 2011 Swann issued three year 5% $30,000 loans notes at nominal value when the
effective rate o f interest is also 5%. The loan notes will be redeemed at par. The liability is
classified at FVTPL. At the end of the first accounting period market interest rates have risen to
6%.

Required
Explain and illustrate how the loan is accounted for in the financial statements of Swann in the
year ended 31 December 2011.

Solution
Swann is receiving cash that is obliged to repay so this financial instrument is classified as a
financial liability. The liability is classified at FVTPL so, presumably, it is being held for trading
purposes or the option to have it classified as FVTPL has been made.

Initial measurement is at the fair value of $30,000 received and, although there are no
transaction costs in this example, these would be expensed rather than taken into account in
arriving at the initial measurement.

With an effective rate of interest and the coupon rate both being 5%, at the end of the
accounting period the carrying value of the liability will still be $30,000. This is because the
finance cost that will increase the liability is $1,500 (5% x $30,000 – the effective rate applied to
the opening balance), and the cash paid reducing the liability is also $1,500 (5% x $30,000 – the
coupon rate applied to the nominal value).

As the liability has been classified as FVTPL this carrying value at 31 December 2011 now has to
be revalued. The fair value of the liability at this date will be the present value (using the new
rate of interest of 6%) of the next remaining two years' payments.
As Swann has classified this liability at FVTPL, it is revalued to $29,450. The reduction of $550 in
the carrying value of the liability from $30,000 is regarded as a profit, and this is recognised in
the statement of profit or loss. If, however, the higher discount rate used was not because
general interest rates have risen, rather the credit risk of the entity has risen, then the gain is
recognised in other comprehensive income. This can all be summarised in the following
presentation.
In regards to the accounting in the remaining two years. The finance charge in SOPL for the year
end 31 December 2012 will be the 6% x $29,450 = $1,767,
The cash payment of $ 1,500 being made, the carrying value of the liability will be $29,717
($29,450 + $ 1,767 - $1,500) at the year end.

If at 31 December 2012 the market rate of interest has fallen to, say, 4%, then the fair value of
the liability at the reporting date will be the present value of the last repayment due of $31,500
in one year's time discounted at 4% (ie $31,500 x 0.962 = $30,288), which in turn means that as
the fair value of the liability exceeds the carrying value, a loss of $571 (ie $30,288 less $29,717)
arises which is recognised in the statement of profit or loss.

In the final year ending 31 December 2013 the finance cost to the statement of profit or loss
will be 4% x $30,288 = $1,212, increasing the liability to $31,500 before the final cash payment
of $31,500 is made, thus extinguishing the liability. When interest rates rise so the fair value of
bonds fall and when interest rates fall then the fair value of bonds rises.

A future article will consider the accounting for convertible bonds and financial assets.
A previous article covered the classification, initial measurement and subsequent measurement
of financial liabilities (eg loans and bonds) and issued equity instruments (eg ordinary shares). It
was established that when issuing financial instruments to raise finance, the issuer had to
classify instrument as either financial liabilities (and, in turn, financial liabilities were split into
amortised cost and Fair Value Through Profit or Loss (FVTPL)) or equity instruments. This can be
summarised in the following diagram.

Accounting for compound financial instruments

While the majority of financial instruments create a financial asset in one entity and a financial
liability or equity instrument in the accounts of another entity, it is possible that a single
financial instrument can create a financial asset in one entity and a financial liability and an
equity instrument in another entity. The classic example of this arises when an entity issues a
convertible bond.

Accounting for the issue of convertible bonds (debt and equity in a single instrument)
Convertible bonds are debt instruments but they also contain an option to convert into equity
shares and this contains both debt and equity elements. The option to convert into equity is
strictly a derivative that is embedded into the host contract. The option will be exercisable by
the holder of the bond who has the option to require settlement of the debt in equity shares
rather than being repaid in cash. It will be necessary on initial recognition to split out the debt
and equity elements so that they can be separately accounted for. The fair value of the option
is highly subjective, but the fair value of the debt element is more easily measured by
discounting the future cash flows. The assumption is then made that the fair value of the option
is the balancing figure.
Example 1

Graham Gooch issues a 3% $200,000 two-year convertible bond at par. The effective rate of
interest of the instrument is 8%. The terms of the convertible bond is that the holder of the
bond, on the redemption date, has the option to convert the bond to equity shares at the rate
of 10 shares with a nominal value of $1 per $100 debt rather than being repaid in cash.
Transaction costs can be ignored. Graham Gooch will account for the financial liability arising
using amortised cost.

Required
Explain the accounting for the issue of the convertible bond.

Solution
A convertible bond creates both an equity and a debt instrument. On initial recognition the
debt element will be measured at fair value – ie the present value of the future cash flow, with
the equity element representing the balancing figure. Transaction costs have been ignored, but
would have to split proportionately between the debt and equity elements. The value ascribed
to the equity element is the balancing figure.
The Cr to equity can be reported in a reserve entitled ‘Other components of equity’. Equity is
not subsequently remeasured. The liability on the other hand will be accounted for using
amortised cost charging income with a finance cost at the rate of 8%.
At the end of Year 2 the liability can be extinguished by the payment of $200,000 in cash, or if
the option is exercised by the bond holder, then it is extinguished by the issue of 20,000 $1
ordinary shares at nominal value with a share premium of $180,000 also being recorded.
Financial assets
There have been some recent changes following the issue of IFRS 9, Financial
Instruments which will supersede IAS 39, Financial Instruments: Recognition and Measurement.
The new standard applies to all types of financial assets, except for investments in subsidiaries,
associates and joint ventures and pension schemes, as these are all accounted for under various
other accounting standards.

IFRS 9, Financial Instruments has simplified the way that financial assets are accounted. As with
financial liabilities the standard retains a mixed measurement system for financial assets,
allowing some to be stated at fair value while others at amortised cost. On the same basis that
when an entity issues a financial instrument it has to classify it as a financial liability or equity
instrument, so when an entity acquires a financial asset it will be acquiring a debt asset (eg an
investment in bonds, trade receivables) or an equity asset (eg an investment in ordinary
shares). Financial assets have to be classified and accounted for in one of three categories:
amortised cost, FVTPL or Fair Value Through Other Comprehensive Income (FVTOCI). They are
initially measured at fair value plus transaction costs (FVTOCI).
Accounting for financial assets that are debt instruments
A financial asset that is a debt instrument will be subsequently accounted for using amortised
cost if it meets two simple tests.
These two tests are the business model test and the cash flow test.

The business model test is met where the purpose is to hold the asset to collect the contractual
cash flows (rather than to sell it prior to maturity to realise its fair value changes). The cash flow
test will be met when the contractual terms of the asset give rise on specified dates to cash
flows that are solely receipts of either the principal or interest.
These tests are designed to ensure that the fair value of the asset is irrelevant, as even if
interest rates fall – causing the fair value to raise – then the asset will still be passively held to
receive interest and capital and not be sold on.

However, even if the asset meets the two tests there is still a fair value option to designate it as
FVTPL if doing so eliminates or significantly reduces a measurement or recognition
inconsistency (an 'accounting mismatch') that would otherwise arise from measuring assets or
liabilities or recognising the gains and losses on them on different bases. An example of where
it is appropriate to use the fair value option and, thus, avoid an accounting mismatch is where
an entity holds a financial asset that is debt and that carries a fixed rate of interest, but is then
hedged with an interest rate swap that swaps the fixed rates for floating rates. The interest
swap is a financial instrument that would be held at FVTPL and so, accordingly, the financial
asset classified as debt also needs to be at FVTPL to ensure that the gains and losses arising
from both instruments are naturally paired in income and, thus, reflect the substance of the
hedge. If the financial asset classified as debt was accounted for at amortised cost, then this
would create the accounting mismatch.

All other financial assets that are debt instruments must be measured at FVTPL.

Accounting for financial assets that are equity instruments (for example, investments in
equity shares)
Equity investments have to be measured at fair value in the statement of financial position. As
with financial assets that are debt instruments, the default position for equity investments is
that the gains and losses arising are recognised in income (FVTPL).
However, there is an election that equity investments can at inception be irrevocably classified
and accounted as FVTOCI, so that gains and losses arising are recognised in other
comprehensive income, thus creating an equity reserve, while dividend income is still
recognised in income.
Such an election cannot be made if the equity investment is acquired for trading. On disposal
of an equity investment accounted for as FVTOCI, the gain or loss to be recognised in income is
the difference between the sale proceeds and the carrying value. Gains or losses previously
recognised in other comprehensive income cannot be recycled to income as part of the gain on
disposal.

For example, let us consider the case of an equity investment accounted for at FVTOCI that was
acquired several years ago for $10,000 and by the last reporting date has been revalued to
$30,000. If the asset is then sold for $31,000, the gain on disposal to be recognised in the
income statement is only $1,000 as the previous gain of $20,000 has already been recognised
and reported in the other comprehensive income statement.
IFRS 9 requires that gains can only be recognised once. The balance of $20,000 in the equity
reserves that relates to the equity investment can be transferred into retained earnings as a
movement within reserves.

The accounting for financial assets can be summarised in the diagram below.

Reclassification of financial assets

As we have seen once an equity investment has been classified as FVTOCI this is irrevocable
so it cannot then be reclassified. Nor can a financial asset be reclassified where the fair value
option has been exercised. However if, and only if the entity's business model objective for its
financial assets changes so its previous model assessment would no longer apply then other
financial assets can be reclassified between FVTPL and amortised cost, or vice versa. Any
reclassification is done prospectively from the reclassification date without restating any
previously recognised gains, losses, or interest.
Accounting for impairment losses on financial assets
Under the suggested new requirements of IFRS 9, Financial Instruments, only financial assets
measured at amortised cost will be subject to impairment reviews. It is also proposed that an
expected loss model towards impairment reviews be introduced when reviewing these financial
assets. The expected loss model requires that entities determine and account for expected
credit losses when the asset is originated or acquired rather than wait for an actual default. This
is achieved by making an allowance for the initial expected losses over the life of the asset by
considering a reduction in the interest revenue.
Example 2: accounting for impairment losses

Imran Khan holds financial assets that are debt instruments (he is a lender). These assets are
initially recognised at $100,000 and accounted for at amortised cost as they meet the business
model and cash flow tests. Each loan has a coupon rate of 8% as well as an effective rate of 8%.
In the current period no loans have actually defaulted; however, it is felt that a proportion of
loans will default and, thus, in the long run the rate of return from the portfolio will be 3%.

Required
Discuss the impairment review of these assets in the first accounting period using the expected
loss model.

Solution
The gross interest income that is initially recognised in income is $8,000 (as calculated using the
effective rate of 8% on the initial carrying value of $100,000).
With no defaults, cash of $8,000 will also be received (as calculated using the coupon rate of 8%
on the nominal value).
Thus, prior to any impairment review the carrying value at the end of the first reporting period
is $100,000.

However, to recognise the impairment loss on an expected loss basis the actual net rate of
return inclusive of expected defaults of 3% has to be considered. This gives a net $3,000 (3% x
$100,000) to be recognised in income. Thus, there is an expected loss adjustment of $5,000
($8,000 less $3,000) leaving the asset written down to $95,000 ($100,000 less $5,000).

Historically impairment reviews had been accounted using an incurred loss model in order to
recognise an impairment loss, there had first to be a specific past event indicating an
impairment. In the example, on this basis no allowance would have been made of the expected
future losses so that the interest income recognised would be simply $8,000 and the asset
stated at $100,000.

The incurred loss model led to the failure of lenders to recognise known losses and to overstate
assets. The new approach of measuring impairment on an expected loss model is both in
accordance with prudence, in that losses are anticipated and accruals in that the losses are in
effect spread over the period of the life of the asset and not back loaded.