RECOGNITION, CLASSIFICATION & MEASUREMENT OF FINANCIAL

INSTRUMENTS

RECOGNITION

An entity shall recognizes FA or FL on the statement of financial position when, and

only when the entity becomes a party to the contractual provisions of the instrument.

CLASSIFICATION OF FINANCIAL ASSETS

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).

The classification is based on

a) how an entity manages its financial assets (i.e business model) ( if the business model
objective is to collect contractual cash flow ) ; and
b) The contractual cash flow characteristics of the financial asset ( the instruments has
contractual terms that are solely payments for principal and interest on principal)

Eg buy bonds classification

[ to keep + just interest & capital] AC

[To keep some + sell some] + just interest and capital ] FVTOCI
Others … held for sale or trading FVTPL

Eg buy shares classification

[ to keep ].. need to choose this ( irrecovable) FVTOCI

[To sell ] FVTPL

FA shall be measured at amortised cost if BOTH the following conditions are met:

1. The FA is held within the business model whose objectives is to hold the asset in
order to collect contractual cash flow; and
2. The contractual terms of the FA give rise on specifies dates to cash flows that are
solely payments of principal and interest on principal outstanding

• The amortised model can only be used to debt instruments that have a fixed
maturity date

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 • For a debt instruments, an entity that applies the amortised cost model would
earn a constant rate . Changes in fair value are not recognised

FA shall be measured at FVTOCI if BOTH the following conditions are met:

1. The FA is held within the business model whose objectives is achieved by both
collecting contractual cash flows and selling the assets; and
2. The contractual terms of the FA give rise on specifies dates to cash flows that are
solely payments of principal and interest on principal outstanding

• Interest income, impairment losses and exchange gains and losses and any gain or
loss on derecognition are recognized in profit or loss.
• All other gains or losses shall be recognized in OCI.

FA shall be measured at FVTPL if it is NOT measured at AC or FVTOCI. This is

known as the residual class.

EG. A debt instrument held for trading must be measured at fair value through profit or
loss even if it has contractual cash flows of principal and interest on principal.
are met:

MEASUREMENT

INITIAL MEASUREMENT OF FA

◼ In MFRS 9 , the measurement for debt instruments depends on whether the criteria are met:
1. The entity’s business model for managing the financial assets ( if the business
model objective is to collect contractual cash flow) ; and
2. The contractual cash flow characteristics of the financial asset ( the instruments
has contractual terms that are solely payments for principal and interest on
principal)

◼ General rule ; if both criteria are met, the FA is classified as measured at amortised cost. All
other instruments, including unquoted instruments, shall be measured at fair value.

◼ MFRS13 Fair value Measurement provides guidance on the fair value measurement
considerations as follows:
a. If the asset is quoted in an active market, the published price quotation is the best
evidence of fair value

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 b. If the asset is not quoted in an active market, the fair value shall be determined by a
valuation technique.

SUBSEQUENT MEASUREMENT OF FINANCIAL ASSETS

Important terms: TLT 6 ed vol 2 p8

1. amortised cost of FA or FL

The amount in which the FA or FL is measured at initial recognition minus principal

repayment, plus or minus the cumulative amortisation using the effective interest
method of any difference between initial amount and the maturity amount, and
minus any reduction (directly or through the use of an allowance account) for
impairment or uncollectibility.

year Op balance effective Actual interest Closing

interest paid balance
a b ( c) a+b-c

2. effective interest method

A method of calculating the amortised cost of a FA or FL, and allocating the interest
income or interest expense over the relevant period

3. effective interest rate

The rate that exactly discounts estimated future cash payments or receipts through
the expected life of the financial instrument or, when appropriate, a shorter period
to the net carrying amount of the FA or FL

◼ Under MFRS 9 FA are measured subsequent to recognition either at :

✓ at amortized cost, or
✓ fair value (through profit or loss (FVTPL) or fair value through other comprehensive income
(FVTOCI) )

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 Financial Assets

Eg buy Debt Equity Eg Buy shares

bond instruments instruments

Contain an Evidence of an ownership

obligation to interest in the residual net
be repaid assets

If classified at If classified at FVTPL: If classified at

amortized cost: Initial measurement at FVTOCI:
Initial measurement fair value ( transaction Initial measurement at
at fair value plus costs directly written off fair value plus
transaction costs, to P/L), and transaction costs, and
and Subsequent also at FV Subsequent also at FV
Subsequent at with gains or losses with gains or losses
amortized cost recognized in Profit or recognized directly in
Loss reserves and OCI

The business model The default accounting An **irrevocable

and cash flow test treatment. Also used election at inception
have to be met where the asset is has to be made. On
acquired for trading disposal no recycling
purposes or to avoid an of previously
accounting mismatch recognized gains or
losses to profit or loss.

**Irrevocable election- is an election where you classify the thing to OCI and you can’t
reclassify it to P/L no matter what

Illustration See eg 5 JL 4th ed p177

An entity is considering how to classify the following assets and financial liabilities

a. Investment in equity shares that has an active market and which the entity intends to take
short-term profits. It trades on these types instruments.
b. An account receivable that is not held for trading.
c. Investment equity shares quoted in an active market that is not held for trading but the
entity made an irrevocable election at initial recognition.
d. Purchase of convertible loan that is quoted in an active market and is not held for trading.
e. Purchase of debt instrument that is quoted in an active market and is not held for trading
but the entity intends to hold it to maturity. However, if the market interest rates fall, it
intends to sell.

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f. A `strategic’ investment in an equity instrument that is not quoted in an active market and
the entity has no intention of selling it.

Solution
a. Classified as measured at FVTPL
b. Classified as measured at amortised cost
c. Classified as measured at FVTOCI
d. Classified as measured at `FVTPL’ because of the inclusion of the conversion option
which is not deemed to represent payments of principal and interest. An irrevocable
election can be made at initial recognition to measure it at ‘FVTOCI’
e. Classify as measured at `amortised cost’ if it meets the business model and contractual
cash flow tests.
F. Classified as `FVTOCI’ if irrevocable election is made at initial recognition.

Example 1 Accounting for financial assets that are debt instruments using amortized cost
(Lazar Ex 9(a), pg 186)

On 1 January x1, JKL purchased a debt instrument that will mature in four years’ time for RM5
million, which is its fair value. The face value of the instrument is RM6 million with a notional
interest rate of 4.7%. The market interest rate is 10%.

JKL classified the asset as measured at amortized cost.

Required: Prepare extracts of the statement of profit or loss and statement of financial
position.
NOTE : notional interest rate= coupon interest rate
ANSWER:
Year Amortized cost Interest income Cash flow Amortized cost
at beginning of of 10% (interest receivable) of at year-end
the year (effective 4.7% on RM6,000,000 (Closing amount)
(opening balance) interest at 10%) (Interest paid)
RM’000 RM’000 RM’000 RM’000
1 5,000 500 ( 282 ) 5,218
2 5,218 522 ( 282 ) 5,458
3 5,458 545 ( 282 ) 5,721
4 5,721 561 * ( 282 ) 6,000
* Rounding error

Statement of Profit or Loss (extract)

Year 1 2 3 4
Interest Income 500 522 545 561

Statement of Financial Position (extract)

Year 1 2 3 4
Non current assets:
Financial asset 5,218 5,458 5,721 6,000

i. 1 Jan 20x1 - To recognize the acquisition of investment at FV (initial

measurement)

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 Dr: Financial Assets at amortised cost (Investment in a debt 5,000
instrument)
[5 million + transaction costs, if any]
Cr: Cash 5,000

ii. Journal entry for the fair value change at each year-end (subsequent measurement):

20x1 20x2 20x3 20x4

Dec 31 Dr Investment in a debt instrument (bal. Figure) 218 240 263 279
Dr Cash / Interest receivable (the coupon 282 282 282 282
interest)
Cr Interest Income 500 522 545 561

iii. Disposal of investment at maturity date

20x4
Dec 31 Cash 6,000
Investment in a debt instrument [Opening bal 5,721 + 279] 6,000
Cash received on sale of investment at maturity

Example 2 Accounting for financial assets that are debt instruments using amortized cost
(Lazar Ex 9(b), pg 187)

Example 3 Accounting for financial assets that are equity instruments

(Lazar Ex 8, pg 185)

On 1 Nov 20x4, High acquired 5,000 quoted shares of Rainbow for RM25,000. It
incurred transaction costs of RM1,000. The fair value of these shares on 31 Dec 20x4
was RM26,200.
High wants to classify the investments as:

a) Fair value through profit or loss (FVTPL), or

b) Fair value through other comprehensive income (FVTOCI)

Required: Show journal entries to record the acquisition of shares.

ANSWER
a) Fair value through profit or loss

i. 1 Nov 20x4 - To recognize the acquisition of shares at FV

Dr: Financial Assets at FVTPL (Investment in Rainbow)

Dr: Transaction cost / P or L
Cr: Cash

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 ii. 31 Dec 20x4 - To recognize the change in the fair value (subsequent
measurement)

Dr: Financial Assets at FVTPL (Investment in Rainbow)

Cr: Profit or Loss

b) Fair value through OCI

i. 1 Nov 20x4 - To recognize the acquisition of shares at FV plus transaction costs:

Dr: Financial Assets at FVTOCI (Investment in Rainbow)

Cr: Cash

ii. 31 Dec 20x4 - To recognize the change in the fair value (subsequent
measurement)

Dr: Financial Assets at FVTOCI (Investment in Rainbow)

Cr: OCI (Equity/ Fair value reserve)

Note: 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 OCI cannot be recycled
or re-classified to income as part of the gain on disposal (in SOPL), although they
may be reclassified in equity.

Reclassification of financial assets (see MFRS 9, Lazar 4th ed, Ch 10, pg 180)

• 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.

CLASSIFICATION OF FINANCIAL LIABILITIES

On recognition, MFRS 9 requires financial liabilities are classified as measured at :

a. Fair value through profit or loss ( if they are held for trading or are designated at
FVTPL upon initial recognition); or
b. Amortised cost

Examples of `held for trading’ for FL are:

a. Derivative liabilities that are accounted for as hedging instruments;

Esmie/MR/FAR660/Financial Instruments 7
b. Obligations to deliver securities or other financial assets borrowed by a short seller.
c. Financial liabilities that are incurred with the intention to repurchase them in the near future;
and
d. Part of a portfolio of identified financial liabilities, manage together and which have a recent
pattern of short-term profit taking

Issuing financial instruments

(raising finance)

Financial liabilities Equity instruments

Contain an Evidence of an
obligation to ownership interest in the
repay residual net assets

If classified at If classified at Initial measurement is at

amortized cost: FVTPL: fair value less issue costs.
Initial Initial measurement NO change as equity
measurement at at fair value, and any instruments are not
fair value less transaction costs are remeasured.
issue costs, and immediately written
Subsequent at off to profit or loss.
amortized cost Subsequent also at
FV with gains or
losses recognized in
Profit or Loss

EQUITY INSTRUMENTS
- Equity instruments are initially measured at fair value less any issue costs.
- Equity instruments are not remeasured.

Example 5: Accounting for the issue of equity

Nita issues 10,000 ordinary shares for cash consideration of RM2.50 each. Issue costs are
RM1,000.

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

Answer
- Entity has raised finance (received cash) by issuing financial instruments

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- 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.
- Issue costs are written off against share premium.

Dr Cash [25,000 – 1,000 issue cost] 24,000

Cr: Share capital 24,000

Financial Liabilities
- Contains an obligation to repay.
- Financial liabilities are then classified and accounted for as either:
(i) at amortized cost, or
(ii) fair value through profit or loss (FVTPL)

- The default position is, and the majority of financial liabilities are, classified and accounted for
at amortised cost.

A. Accounting for a financial liability at amortized cost (using effective interest rate
method)

- initially measured at fair value minus any transaction costs

Example 6:
Summit raises finance by issuing RM20,000, 6% four-year loan notes on 1 January 20x1. The
loan notes are issued at a discount of 10%, and will be redeemed after four years at a premium of
RM1,015. The effective rate of interest is 12%. The issue costs were RM1,000.

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

Answer:

• Initial measurement of financial liability at 1 January 20x1 is at fair value of consideration

received less transaction costs.

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

Cash received: RM
Nominal value 20,000
Less: 10% Discount on issue ( 2,000) 18,000
Less: Transaction costs (1,000)
Initial recognition of the financial liability 17,000

20x1
1 Jan Initial measurement and recognition
Cash 17,000
Loan Notes 17,000
Issued RM20,000 6% loan notes at a discount
OR

Esmie/MR/FAR660/Financial Instruments 9
 20x1 Initial measurement and recognition
1 Ja (i) Cash received
n
Cash 18,000
Loan Notes 18,000
Issued RM20,000 6% loan notes at a discount

(ii) Payment of issue costs

Loan Notes 1,000
Cash 1,000

Under this method, the closing liability balance at the end of each year increases. At the end of
the loan term, the balance of the liability is extinguished (ie derecognized) by the repayment of
the principal amount plus premium.

• Subsequent Measurement
The amount of liability (in the SOFP) and the amount of finance costs charged as an expenses
in the SOPL are as per the following schedule.

Cash Paid
Finance charge (@ Coupon Repayment of principal Closing
Opening effective interest rate) interest amount balance of
Year balance 12% on opening [6% x (RM20,000 at a liability
balance RM20,000 premium of RM1,015) (to SOFP)
A B C C A+B-C
20x1 17,000 2,040 ( 1,200 ) 17,840
20x2 17,840 2,141 ( 1,200 ) 18,781
20x3 18,781 2,254 ( 1,200 ) 19,835
20x4 19,835 2,380 ( 1,200 ) (21,015 ) Nil
Total finance costs 8,815
Note: The amortization of the premium or discount is the difference between the interest expense
and the coupon interest payable on the bond (ie B – C).

Journal entry for the finance costs at year-end (charged to SOPL):

20x1 20x2 20x3

Dec Finance cost 2,040 2,141 2,254
31
Loan Notes 840 941 1,054
Cash (payment of the coupon 1,200 1,200 1,200
interest)

At the end of Year 4 - redemption of the loan notes

20x4
Dec 31 Finance cost 2,380
Loan Notes 1,180

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 Cash (payment of the coupon interest) 1,200

6% Loan Notes [Opening bal 19,835 + 1,180] 21,015

Cash 21,015
Loan notes redeemed at a premium

B. Financial liabilities at FVTPL (not usual)

- Financial liabilities are only classified as FVTPL if they are held for trading or the entity so
chooses.

- Financial liabilities that are classified as FVTPL are initially measured at fair value and any
transaction
costs are immediately written off to the income statement.

Example 7: Accounting for a financial liability at FVTPL

On 1 January 2011 Nita issued three year 5% RM30,000 loans notes at nominal value when the
effective rate of 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
How is the loan to be accounted for in the financial statements of Nita in the year ended 31
December 2011.

Answer:
Initial measurement is at the fair value of $30,000 received and, any transaction would be
expensed.

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.

Cash flow Discount PV of future

RM factor 6% cash flows
RM
Payment due 31 December 2013 (the final interest 31,500 0.890 = 28,035
payment RM1,500 plus the repayment of the
RM30,000)
Payment due 31 December 2012 (interest only) 1,500 0.943 1,415

Fair value of the liability at 31 December 2011 29,450

The reduction of RM550 in the carrying value of the liability from RM30,000 is regarded as a
profit, and this is recognised in the income statement.

Esmie/MR/FAR660/Financial Instruments 11
Accounting for COMPOUND FINANCIAL INSTRUMENTS

A compound financial instrument is financial instrument that contains both a liability and
an equity element.

Presentation - to classify as financial liability and equity.

To be discussed in the next topic.

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