Lecture 6 – Financial Instruments

Overview of financial instruments

DEFINITION
• Para 11 AASB 132
o Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity
• Must be 2 parties in a contract that are external to each other
o Cannot be related parties
o That is not governed by AASB 132, will be covered by another standard
• For financial instruments:
o One party has a financial asset ® holder of instrument
o The other party has a financial liability/ equity instrument ® issuer of instrument

TYPES OF FINANCIAL INSTRUMENTS

Primary
• Instruments that derive
their value directly from
the market
• Eg cash, receivables,
payables, purchased
bonds, issued bonds
Derivative
• Instruments that derive
their value from an
underlying item
• Cannot derive value
directly from market,
depends on the underlying
item (eg interest rate,
stock price) to determine
the value of the derivative
• Eg call/put options
purchased, call/put options
issued, forward contracts
Singular
• A contract that gives
rise to a single financial
asset, financial liability
or equity instrument
• Eg loan receivable, loan
payable, equity
instruments issued
Compound
• A contract that gives rise
to a combination of a
financial asset, financial
liability or equity
instrument
• Eg convertible debt
(consists of liability and
equity components)

• Financial institutions may hold a huge number of financial instruments, but financial instruments are prevalent amongst all
businesses – eg all businesses have cash

DERIVATIVE FINANCIAL INSTRUMENTS

• Value changes in response to underlying item
• Is settled at a future date
o Eg call/ put option ® option will be settled in the future
• Requires no initial net investment or an initial net investment that is smaller than would be otherwise required
o Very little to none initial net investment needed
o Eg enter into call option to buy 100 Qantas shares in 3 months’ time at 5AUD/ share; if want to buy the shares today,
would have to pay $500 but if enter into call option, will only have to pay very little to enter into this contract (will be
lower than $500) ® hence initial net investment is much smaller than would otherwise be required

SCOPE – AASB 132

• Under certain circumstances, even though holding a type of financial instrument, must apply another standard bc those instruments
are of a special type (not use AASB 132)
• These are covered under different accounting standards:
o Rights or obligations for employee benefits for which AASB 119 Employee Benefits applies
o Share based payment transactions for which AASB 2 Share based Payment applies
o Interests in subsidiaries accounted for in accordance with AASB 127 Consolidated and Separate Financial Statements
o Interests in associates accounted for in accordance with AASB 128 Investments in Associates
o Interests in joint ventures accounted for in accordance with AASB 131 Interests in Joint Ventures

TRANSACTIONS THAT DON’T RESULT IN FINANCIAL INSTRUMENTS

• Purchase or lease of non-financial assets as control of these assets create an opportunity to generate cash inflows but does not give
a present right to receive cash or another financial asset
o Eg purchase of inventories/PPE, lease of PPE
• Prepayments of cash for goods or services for which the future economic benefit is the receipt of goods or services rather than the
right to receive cash or another financial asset
• Warranty obligations relate to right of customers to repairs or replacement, not a right to receive cash
• Commodity contracts where settlement is by the delivery of a non-financial asset
o Eg a forward contract to buy wheat – settlement is by the delivery of a physical asset
• Rights or obligations due to statutory requirements
o Eg tax liabilities – right to pay cash but bc obligatory under statutory requirements, not financial instrument
 Future liability to pay cash to the
bank = financial liability for the bank

TR = financial asset bc entitles you to

receive cash in future

Investment in subsidiaries = financial

asset if you hold shares in the
subsidiary, or if you lend money to
the subsidiaries

Financial assets
DEFINITION
• Financial asset definition laid out in 4 sections under AASB Para 11
• AASB 132 Para 11(a)
o Cash is a financial asset
• AASB 132 Para 11(b)
o Equity instrument of another entity other than shares in a subsidiary, JV or an associate
o Eg shares in an external entity is a financial asset
• AASB 132 Para 11(c)
o A contractual right
§ To receive cash or another financial asset from another entity
Þ Eg accounts receivable, debentures held
§ To exchange financial assets or financial liabilities with another entity under conditions that are potentially
favourable to the entity
Þ Eg call or put options held (holder will only exercise under favourable conditions), foreign exchange
• AASB 132 Para 11(d)
o A contract that will or may be settled in the entity’s own equity instruments
§ A non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own
equity instruments
Þ Eg a contract to receive at a future date as MANY of the entity’s own equity instruments as are equal in
value to $300m ® don’t know how many shares you will receive, is determined based on share price
§ A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial
asset for a fixed number of the entity’s own equity instruments
Þ Entering into a fixed to variable, or variable to variable, or variable to fixed contract to exchange
financial asset with your own equity instrument
* As long as there is a variable involved in the exchange, will be financial instrument ® if it is
fixed to fixed; then there is only equity risk involved, no financial risk so not financial
instrument
Þ Eg a contract to receive at a future date as MANY of the entity’s own equity instruments as are equal in
value to 300 ounces of gold at that date (variable to variable)

INITIAL MEASUREMENT – FINANCIAL ASSETS

• Fair value of financial asset + any transaction costs that are directly attributable to its acquisition
• Transaction costs ® incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or
financial liability
o Costs that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument
o Exception: transaction costs not included if financial asset subsequently measured at fair value through profit and loss
§ Underlying logic – if financial asset is going to be subsequently measured at FV in the P&L, even if include
transaction costs into FV now, will end up expensing the costs right away ® hence no point including it in the
equation
SUBSEQUENT MEASUREMENT – FINANCIAL ASSETS

First, identify what type of financial asset you are holding

Second, does it satisfy the contractual cash flow test

If derivative ® FV through P&L

If equity instrument ® trading = FV through P&L; not

trading = FV through P&L or FV through OCI

If debt instrument ® FV through P&L, FV through OCI or

Amortized cost depending on whether pass business
model test

FVOCI ® for hold and sell options under debt & equity
only

• Contractual cash flow test:

o Holding financial assets means that you expect to be better off in the future ® bc will be receiving cash in future
o Tests future cash flows to see if it consists of only interest and prepayment of principal ® only debt instruments meet the
test requirements
o Derivatives will never meet the contractual cash flow test
§ Measurement will be at FV through P&L
o Equity instruments will never satisfy the contractual cash flow test
§ FCF usually consists of dividend price you receive, or the share price differences from sale
• Equity instruments can be held for 2 reasons:
o Held for trading ® measurement will be at FV through P&L
o Not held for trading, holding for long term ® then can choose to measure FV through OCI or at FV through P&L
§ Recognition on OCI means loss and gains will not impact net profit; directly influences equity
• Debt instrument
o Eg lending money to others
o Passes the contractual cash flow test
o Must also undergo business model test – what is the purpose of holding the debt instrument?
§ Holding only to receive contractual cash flows; intention is to receive interest and prepayment of principal when
it matures ® then meets the business model test
Þ Then can choose between FV through P&L or Amortized cost (only for debt instruments that meet
business model test)
§ Holding to collect contractual cash flows & also for sale
Þ Then can choose between FV through P&L or FV through OCI
Þ Meets the business model test
§ Holding to sell or for short term trading profit
Þ Does not pass business model test
Þ Measurement at FV through P&L

Amortised cost = Amount recognised at initial recognition principal repayments ±cumulative amortisation using the effective
interest method of any difference between that initial amount and the maturity amount – any reduction for loss allowance
• Both conditions must be met:
o Cash flow (CF) characteristics test
§ Contractual terms give rise to cash flows that are Solely Payments of Principal and Interest (SPPI); and
o Business model (BM) test
§ Objective is to hold financial assets to collect contractual cash flows
EXAMPLE – BUSINESS MODEL & CASH FLOWS TEST

Can choose between amortized cost and FV on P&L

Can choose between FV through OCI or at FV through P&L

Can choose between amortized cost and FV on P&L

Short term debt instruments here, but practice is to reinvest

into more debt instruments and hold it to collect contractual
cash flows ® so is not trading and passes business model test

IMPAIRMENT OF FINANCIAL ASSETS

• AASB 9 Financial Instruments
• Uses the Expected loss model for:
o Financial assets measured at amortised cost ® like bad debt allowance
§ Loss allowance is shown as a contra asset
§ Dr: Impairment loss (P&L)
Cr: Loss allowance (Contra asset in Balance sheet)
o Financial assets with contractual cash flows measured at FVOCI
§ Loss allowance is credited to OCI
§ Dr: Impairment Loss (P&L)
Cr: Loss allowance (OCI)

EXPECTED CREDIT LOSSES (ECL)

• 2 approaches used to estimate ECL – simplified or general approach

Simplified Approach General Approach

• Loss allowance uses lifetime ECL directly • Must be used for receivables with significant financing component, if
• Use simplified approach for receivables with simplified appraoch not elected
no significant financing component • 3 staeg approach depending on credit risk
First stage
• 12 month ECL bc there is no significant deterioration in credit risk
• Interest revenue = effective interest rate on the gross CA
• Expected loss ® booked there as a provision type of account, but
when calculating interest revenue must still use gross amount

Second stage
• Lifetime ECL when credit risk increases significantly
• Interest revenue = effective interest rate on the gross CA

Third stage
• Lifetime ECL when credit risk increases significantly & credit is
impaired
• Interest revenue = based on amortized cost (gross CA – loss
allowance)
• Here, not only interest at risk, there is also a risk of being able to
receive the principal payment
EXAMPLE – ECL
Interest due at settlement date ® means that during the period
of the loan, won’t be receiving interest on an annual basis, will
only receive all the interest at the end of the loan

Implicit interest rate = effective interest rate

Step 1: Calculate PV of loan receivable

• PV of FCF that will be received ® includes both principal and
interest

Step 2: Create loan repayment schedule

Total interest = accumulated interest over loan term; must discount
back to PV as well (500k*8% = 1 year of interest)

Interest income ≠ interest received

• Interest received ® cash already received (only at end of loan in
this case)
• Interest income ® interest earned in the period it is incurred

Closing balance = opening bal + interest ® is the amortized cost

• At end of loan, closing balance must equal principal entitled
to receive

Provision type of account must be made ® which is ECL

• Since the company estimates their expected credit
loss (ECL) to be $5,000 and is at stage 1
• Like bad debts provision

Financial liabilities
DEFINITION
• AASB 132 Para 11 (a)
o Contractual obligation
§ To deliver cash or another financial asset to another entity
Þ Eg bank overdraft, loan payable, debentures issued
§ To exchange financial assets or financial liabilities with another entity under conditions that are potentially
unfavourable to the entity ® end up worse off after delivering
Þ Eg issued call or put options (issuer obliged to sell under unfavourable conditions)
• AASB 132 Para 11 (b)
o A contract that will be settled in the entity’s own equity instruments
§ A non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity
instruments
Þ Eg a contract to deliver as many of the entity’s own equity instruments as are equal in value to $300m
§ A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another
financial asset for a fixed number of the entity’s own equity instruments
Þ Must not be fixed to fixed
Þ Eg a contract to deliver at a future date as many of the entity’s own equity instruments as are equal in
value to 300 ounces of gold at that date (this is a variable to variable; exact amount of shares that you
need to deliver depends on the share price and price of gold)

INITIAL MEASUREMENT – FINANCIAL LIABILITIES

• Fair value of financial liability – any transaction costs that are directly attributable to its issue
o Exception: transaction costs not included if financial liability subsequently measured at fair value through profit and loss
SUBSEQUENT MEASURMENT – FINANCIAL LIABILITIES

For both financial assets & liabilities, derivatives must be subsequently

measured at FV through P&L

If holding financial liability and it is a debt instrument (eg borrowing money

from other entities):
- Held for trading (short term), not interested in loan but buy the
bond to sell ® subsequently measured at FV through P&L
- Not held for trading, keeping the debt instrument ® have a
choice between measuring at FV through P&L or Amortized cost

Note: FV changes attributable to changes in own credit risk must be shown

in OCI unless doing so creates or enlarges an accounting mismatch

EXAMPLE – DERIVATIVE INSTRUMENTS

This is a derivative; underlying financial instrument = shares of Wesfarmers

- Value of derivative changes in response to changes in the share
price of Wesfarmers

Since ABC Ltd is the writer/ issuer of the call option, it is a financial liability to
them ® they have the contractual obligation to sell at the predetermined
price if the holder/ buyer decides to exercise the option
- holder (other party) has the right to decide whether or not they
want to exercise the option, and will only exercise when it is
favorable to them Exercise price = $45, market price = $43 ® at aug 2016, holder will not
exercise option bc will need to buy the stock at higher price than market; so
Written call option is a derivative that must be measured at FVTPL on is a gain to ABC
subsequent measurement
Cannot directly recognize all the gains of the call option together at Jun ®
still have 2 months to go before maturity/ exercise date

This is a derivative; underlying financial instrument = shares of Afterpay

- Value of derivative changes in response to changes in the share
Gain = price difference on date of measurement * no. of shares
price of Afterpay
Value of call option increases, so need to recognize a gain incrementally
Since Liu is buyer/ holder of the call option, it is a financial asset to them ®
Liu has the right to buy at predetermined price if they decide to exercise the
option
- holder decides whether they want to exercise the option or not,
will only exercise if it is favorable to them

Derivative financial assets must be measured at FVTPL on subsequent

measurement

Cash = price option holder needs to pay to exercise the option

Bought call options = price paid to buy options transferred to shares
(surrendered options)
Equity instruments
DEFINITION
• Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities
• Must include no contractual obligation to deliver financial assets to another entity OR exchange financial assets or financial liabilities
unfavourable to the issuer
• If the only risk attached to instrument is ‘equity risk’, then classified as equity instrument
o No financial risk at all
o Eg ordinary shares, some type of preference shares

IMPORTANCE OF DEBT/ EQUITY DISTINCTION

• ‘substance over form’ test must be applied (AASB 132.15)
o Need to analyze the characteristics of the financial instrument to determine if it is an equity or debt instrument ® just bc it
is classified/ labelled as such, doesn’t mean it is actually what it claims
§ Eg shares; may exhibit more characteristics of a financial liability than equity, then would be classified as liability
o Managers have incentives to ‘misclassify’ as equity instrument
• Importance of distinction:
o Follows principal classification ® very different treatment towards future cash flows
§ Debt classification – periodic payments treated as interest
§ Equity classification – periodic payments treated as dividends
o Affects debt/equity ratios
§ Debt classification – may result in debt covenant violations
Þ Covenant may require the maintenance of a certain D/E ratio, otherwise will breach the covenant & the
lender will be entitled to ask for immediate repayment
o Financial institutions
§ Debt classification – may affect capital adequacy requirements

PREFERENCE SHARES: DEBT OR EQUITY

• Whether preference shares are to be treated as debt or equity instrument, depends on PARTICULAR RIGHTS attached to the
preference shares
o If contractual obligation exists for redemption on a specific date OR at option of the holder of the preference share ®
issuer has a financial liability
§ Holder has the option/ right to redeem the shares; so issuer has present obligation for future cash outflows
o If preference shares are non-redeemable, and dividend distributions (whether cumulative or non-cumulative) are at the
discretion of the issuer ® equity instruments
§ If it is the issuer who has a say on whether the holders can redeem the shares or not, then there is no present
obligation for future cash outflows (no present obligation to transfer financial assets)
o If preference shares are redeemable at option of the issuer for cash ® equity instrument
§ Same as non-redeemable; no present obligation for future cash outflows (no present obligation to transfer
financial assets)

EXAMPLE – REDEEMABLE PREFERENCE SHARES

A has a present obligation to pay dividends each year,

so it is a financial liability

COMPOUND FINANCIAL INSTRUMENTS

• Compound financial instruments are non-derivatives ® focus is on convertible notes
• Combines debt instrument with an embedded conversion option
o Eg holder of convertible note can convert the note into a fixed number of ordinary shares
• Issuer must present liability component separately from the equity component in its Balance Sheet
o Financial liability = PV of financial liability
o Equity component = Issue proceeds – PV of the financial liability
§ Is the residual portion of the financial instrument
EXAMPLE – CONVERTIBLE DEBT

Convertible notes provide an option to the holder to convert the

note at any time into ordinary shares; hence pay less interest on
convertible notes
• Equity component = fixed to fixed; 1 note to 1 share
Discount rate = market interest rate • Discounted @ 1.085 = 0.6806

Same as before, but now for the issuer ® issuer can decide
whether to redeem the notes or not; but only after maturity

• Still have equity risk ® bc holder can still redeem at anytime

• Only financial liability is interest ® bc issuer can choose whether
or not to allow the notes to be redeemed at the end
• When the option is with the issuer, the equity component takes a
larger portion of the convertible notes ® financial liability
component only covers interest

Demonstration example
Barooga Ltd issues 2,000 $100 convertible notes on 1 July 2014 for a cash consideration of $200,000 with a 6-year maturity.
The notes pay interest at 3% p.a. in arrears on 30 June. ® in arrears = paid at the end of the year
At maturity, each note is convertible into 100 ordinary shares.
At the date of issue, market rates for similar notes without the conversion option are at a coupon rate of 5% p.a.
Barooga Ltd uses amortised cost to subsequently measure the financial liability component of the convertible notes.

Use the residual valuation method to determine the amounts of the financial liability and equity components attributable to the issue of the convertible
notes.

a) What is the amortised cost?

b) Prepare a schedule to determine the amortised cost
c) Prepare journal entries to account for the convertible notes from issue date to the conversion date

STEP 1 – CALCULATE FINANCIAL LIABILITY

PV of future cash flows entitled to pay:
• Interest at 3% p.a. on $200k = $6,000 p.a.
• Interest discounted at 5%:
$6,000 $6,000 $6,000 $6,000 $6,000 $6,000
+ + + + + = $30,454
1.05! 1.05" 1.05# 1.05$ 1.05% 1.05&
• Principal $200,000 due in 6 years’ time discounted at 5%:
$200,000
= $149,243
1.05&
o Bc it is paid in arrears, discount rate has taken into account the time
• 𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = $30,454 + $149,243 = $179,697

STEP 2 – CALCULATE EQUITY COMPONENT

Residual valuation method:
• Residual valuation method is the difference between the issue proceeds and the financial liability
o Option to Convert Notes is an equity account
o It is measured as the difference between the proceeds from the note issue ($200,000) and the present value of the note
liability based on the market rate for equivalent debt ($179,697)
 • To calculate equity component ® take FV of instrument (issue proceeds) – financial liability component

STEP 3 – CALCULATE AMORTIZED COST

Amortized cost:
Value of debt at maturity = principal that needs to be repaid = $200,000

Value of debt at initial recognition = 𝑃𝑉 𝑜𝑓 𝐹𝐶𝐹 = $179,697

Amortized cost = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑎𝑡 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 – 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 𝑎𝑡 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑟𝑒𝑐𝑜𝑔𝑛𝑖𝑡𝑖𝑜𝑛 = $20,303

STEP 4 – PREPARE AMORTIZED COST SCHEDULE

• Similar to financial asset schedule, but asset has interest receivable and interest actually received; liability have obligation to pay so
is interest expense and cash flows actually paid

• Start with amortized cost at the beginning, the initial date ® is the PV of FCF
• Then calculate interest expense ® at market interest rate*opening amortized cost balance
• Then calculate cash flows actually paid; is fixed amount® take rate agreed on in the contract*principal amount
• Lastly calculate amortized cost at end ® how much you need to pay – how much you already paid =
𝒂𝒎𝒐𝒓𝒕𝒊𝒛𝒆𝒅 𝒄𝒐𝒔𝒕 𝒂𝒕 𝒃𝒆𝒈𝒊𝒏𝒏𝒊𝒏𝒈 + 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆 − 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔 = 𝒂𝒎𝒐𝒓𝒕𝒊𝒛𝒆𝒅 𝒄𝒐𝒔𝒕 𝒂𝒕 𝒆𝒏𝒅
• The next year’s opening balance = previous year’s closing balance
• Repeat for remaining period of the convertible note
• At final year, ending balance of amortized cost is exactly equal to the amount of the principal that needs to be repaid

STEP 5 – JOURNAL ENTRIES

When issue convertible notes, will receive cash initially

Need to account for both liability & equity components
separately (Cr Financial component (PV of FCF) and
Equity component)

Also need to account for interest expense incurred every year

Increase convertible note liability ® calculated by taking the

interest expense incurred minus the cash you actually paid;
similar to accumulating the amount you haven’t paid into
your financial liability

At maturity, reduce liability & equity increase ® when notes

converted into shares
DISCLOSURES
• Paragraph 1 of AASB 7 /IFRS 7 requires an entity to provide disclosures that enable users of its financial report to evaluate:
o The significance of financial instruments for the entity’s financial position and financial performance
o The nature and extent of risks arising from financial instruments and how the entity manages those risks
o Basically, when entering into contracts for financial instruments must disclose how it will impact FS and also the risks
associated with it
• Risks include:
o Market risk
§ Currency/interest/other price risk risk that the value of a financial instrument will fluctuate because of changes
in foreign exchange rate/market interest rate/market prices
o Credit risk
§ Risk that one party will fail to discharge an obligation and cause the other party to incur a financial loss
o Liquidity risk
§ Risk that one party will encounter difficulty in meeting obligations at redemption date that is funding risk

SUMMARY
• Financial instruments are contracts which create a Financial Asset in one entity and a Financial Liability or Equity Instrument of
another entity
• Derivative instruments include call options
• Debt/equity distinctions are important
• Equity Financial Assets are measured at FVOCI or at FVTPL
• Debt Instruments held are measured at amortized cost if the business model is to hold to collect contractual cash flows
• Debt instruments held are measured at FVOCI if the business model is to hold and sell financial assets, otherwise FVTPL
• Financial liabilities are measured at fair value with certain exceptions
Tutorial 6
Exercise 11.4 – Distinguishing financial liabilities from equity instruments
Determine whether Aster Ltd has a financial liability or equity instrument resulting from the issue of securities in each situation below.
Give reasons for your answer.
When have an option to convert a note into ordinary shares ® must consider whether it will be converted into a fixed number of shares or a
variable number of shares; this is what constitutes the difference between a financial liability & equity instrument
Also consider if option to redeem is at the option of the holder or issuer ® holder = contractual obligation to pay; issuer = no obligation

1. Aster Ltd issues 100,000 $1 convertible notes. The notes pay interest at 7% p.a. The market rate for similar debt without the
conversion option is 9%. Each note is not redeemable, but it converts at the option of the holder into however many shares that
will have a value of exactly $1.
• Notes pay interest @ 7% ® so there is a contractual obligation for the entity to pay interest every year; is a financial liability
• Converts into however many shares that has a value of $1 ® contractual obligation to deliver VARIABLE number of own equity
instruments; is definition of a financial liability
o Also means there is no equity risk; only a financial risk involved
• This convertible note is a financial liability in full

2. Aster Ltd issues 100,000 $1 redeemable convertible notes. The notes pay interest at 5% p.a. Each note converts at any time at
the option of the holder into one ordinary share. The notes are redeemable at the option of the holders for cash after 5 years.
Market rates for similar notes without the conversion option are 7% p.a.
• Interest per annum ® contractual obligation to pay interest every year; is a financial liability
• Convertible at the option of the holders ® conversion is fixed to fixed; is the definition of equity instrument
o Equity component for the conversion option as it relates to a fixed number of own equity instruments: refer para 16(b).
o Initially measured as the difference between issue proceeds and financial liability component.
o 𝑂𝑝𝑡𝑖𝑜𝑛 𝑡𝑜 𝑐𝑜𝑛𝑣𝑒𝑟𝑡 = $100,000 – $91,801 = $8,199
• Redeemable at the option of the holders for cash ® contractual obligation to pay annual interest and principal at the end of 5 years;
is a financial liability
o Initially measured as the PV of interest and principal discounted at equivalent rate of 7% p.a. for pure play debt security.
o 𝑃𝑉 = $100,000 ∗ 0.7130 + $5,000 ∗ 4.1002 = $91,801

3. Aster Ltd issues 100,000 $1 redeemable convertible notes. The notes pay interest at 5% p.a. Each note converts at any time at
the option of the holder into one ordinary share. The notes are redeemable at the option of the issuer for cash after 5 years. If
after 5 years the notes have not been redeemed or converted, they cease to carry interest. Market rates for similar notes
without the conversion option are 7% p.a.
• Interest per annum ® contractual obligation to pay interest every year; is a financial liability
• Convertible at the option of the holders ® conversion is fixed to fixed; is the definition of equity instrument
o Equity component for the conversion option as it relates to a fixed number of own equity instruments: refer para 16(b).
o Initially measured as the difference between issue proceeds and financial liability component.
o 𝑂𝑝𝑡𝑖𝑜𝑛 𝑡𝑜 𝑐𝑜𝑛𝑣𝑒𝑟𝑡 = $100,000 – $20,501 = $79,499
• Redeemable at the option of the issuer for cash ® issuer does not have a contractual obligation to repay principal at redemption
since redemption is at the issuer’s option; is an equity instrument
o Initially measured as the PV of the interest discounted at equivalent rate of 7% p.a. for pure play debt security.
o 𝑃𝑉 = $5,000 ∗ 4.1002 = $20,501

Exercise 11.6 – Convertible notes issue including financial liability at amortised cost
On 1 July 2024, Parade Ltd issues 2000 convertible notes. The notes have a three-year term and are issued at par with a face value of
$1,000 per note, giving total proceeds at the date of issue of $2 million. The notes pay interest at 4% p.a. annually in arrears. The holder
of each note is entitled to convert the note into 250 ordinary shares of Parade Ltd at contract maturity.

When the notes are issued, the prevailing market interest rate for similar debt (similar term, similar credit status of issuer and similar
cash flows) without conversion options is 8% p.a. Hence at the date of issue:

Prepare the journal entries of Parade Ltd to account for the convertible notes for each year ending 30 June under the following
circumstances.
1. The holders do not exercise their option and the note is repaid at the end of its term.
• Interest at 4% p.a. on $2m = $80,000 p.a.
• Interest discounted at 8% = $206,168
• Principal $200,000 due in 6 years’ time discounted at 8% = $1,587,664
• PV of future cash flows= $1,793,832
• Equity component = $2m - $1,793,832 = $206,168
PARADE LTD
Amortised cost of convertible note liability
Opening bal Interest Paid (4%) Interest Exp (8%) Difference Liability
30 Jun 2025 $1,793,832 $80,000 $143,506.56 $63,506.56 $1,857,338.56
30 Jun 2026 $1,857,338.56 $80,000 $148,587.08 $68,587.08 $1,925,925.64
30 Jun 2027 $1,925,925.64 $80,000 $154,074.05 $154,074.05 $2,000,000
$240,000 $446,167.69
Interest expense = market rate for interest incurred; nominal term of what interest should have been paid based on market
Interest paid = interest actually paid, using the rate that is agreed upon in the contract for this specific convertible note

1/7/24 Cash 2,000,000

Initial Convertible note liability 1,793,832
Option to convert notes (equity) 206,168

30/6/25 Interest expense 143,506.56

Convertible note liability 63,506.56
Cash 80,000

30/6/26 Interest expense 148,587.08

Convertible note liability 68,587.08
Cash 80,000

30/6/27 Interest expense 154,074.05

Convertible note liability 154,074.05
Cash 80,000
Maturity Convertible note liability 2,000,000
Cash 2,000,000

2. The holders exercise their conversion option at the expiration of the contract term.
30/6/27 Interest expense 154,074.05
Convertible note liability 154,074.05
Cash 80,000
Maturity Convertible note liability 2,000,000
Ordinary Share Capital 2,000,000

Exercise 11.8 – Accounting for loan assets at amortised cost

Finale Ltd is a manufacturing company that makes loans to other parties from time to time. The loan assets are classified by Finale Ltd
as subsequently measured at amortised cost. Finale Ltd does not apply the simplified approach to impairment of loans receivable. In
accounting for impairment losses, Finale Ltd classifies all loans as remaining at stage 1 from inception to maturity. On 1 July 2022,
Finale Ltd made the following loans:

A 3-year loan of $1 million to an employee, Mr Whale. The loan is interest free in recognition of his loyalty to the company. Finale Led
estimates 12-months expected credit loss as $30 000.
Prepare the entries of Finale Ltd to account for the loan from initial recognition on 1 July 2022 to derecognition on 30 June 2025,
assuming loans are fully paid on maturity.
Paragraph B5.1.1 of AASB 9:
• ……… Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type
of asset
• In this case, the extra amount lent is to reward Mr Whale for his employee loyalty.
Not told what the market interest rate is, must make assumption of market interest rate; assume it is 10% here
!,(((,(((
𝑃𝑉 𝑜𝑓 𝑙𝑜𝑎𝑛 = !.!(! = 751,315
𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = $1𝑚 − $751,315 = $248,685 ® incurring expense by giving loan interest free

Amortised Cost of Loan Receivable

Period Opening Balance Interest Income Interest Amortisation/ Closing
Interest income ® is the nominal value;
End Received Difference Balance
the income I should have received if I
Jul-22 751,315 gave a similar loan in the marketplace
Jun-23 751,315 75,131 0 75,131 826,446
Jun-24 826,446 82,645 0 82,645 909,091 Interest received ® real cash amount I
have actually received in this loan
Jun-25 909,091 90,909 0 90,909 1,000,000

1/7/22 Loan receivable – Mr Whale (Financial asset) 751,315

Initial Employee expense 248,685
Cash 1,000,000

30/6/23 Loan receivable – Mr Whale 75,131

Interest income 75,131
No cash being received yet so no need to put in an entry

30/6/23 Impairment loss (expense) 30,000

Loss allowance (liability) 30,000
Financial asset must have impairment loss – recognition of 12-month ECL ® just like allowance for doubtful debt

30/6/25 Cash 1,000,000

Maturity Loan receivable – Mr Whale 1,000,000
Loss allowance 30,000
Impairment loss (recovery) 30,000
Reverse impairment loss bc at the end of the final year, there is no more credit risk if you have received the payment in full ® therefore no more
credit loss and must reverse the loss previously accounted for bc of credit risk that employee may not return the principal
Exercise 11.9 – Various financial assets and financial liabilities
Santiago Adventures Ltd has entered into a number of contracts that are financial instruments as follows:
On 1 April 2022, the company acquired 100 000 exchange traded call options in Westside Banking Corporation Ltd at a cost of $3.00
per option. The options have an exercise price of $38.00 and mature on 22 November 2022. The options have a fair value to the holder of
$4.00 each on 30 June 2022 and $5.20 each on 22 November 2022 when the options are exercised.

Prepare the entries of Santiago Adventures Ltd for any financial assets or financial liabilities that arise in each case.

Call options = derivatives

Santiago acquired/ bought the call options ® is a financial asset, has right to decide whether it will exercise the option
Initial measurement = FV (financial asset)
Subsequent measurement = FVTPL (gains & losses go directly into the P&L)

1/4/22 Bought call options (3*100,000) 300,000

Initial Cash 300,000

30/6/22 Bought call options (100,000*(4-3)) 100,000

Gain on call options (P&L) 100,000
Change in FV of shares, increased in value ® so must increase the value of our asset & increase bought call options

22/11/22 Bought call options (100,000*(5.20-4)) 120,000

Gain on call options (P&L) 220,000

22/11/22 Shares in Westside 4,320,000

Maturity Bought call options (5.20*100,000) 520,000
Cash (38*100,000) 3,800,000
Purchase shares at the end at exercise price ® so cash decreases by exercise price*number of shares
Used the call option when buying at exercise price ® so must decrease the asset bought call options by the increase in FV of the shares
Total value of the shares is then the sum of the exercise (cash) + surrender (bought call options) option