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FINANCIAL INSTRUMENT

is any contract that gives rise to both:


Either a financial liability or an equity instrument
of another entity.

A financial asset of one entity

a)
b)
c)

d)

Financial Asset
Cash;
an equity instrument of another entity;
a contractual right:
1.
to receive cash or another financial asset from
another entity; or
2.
To exchange financial assets or financial
liabilities under conditions that are potentially
favorable to the entity
a contract that will or may be settled in the entitys
own equity instruments and is:
1.
a non-derivative for which the entity is or may
be obliged to receive a variable number of the
entitys own equity instruments; or
2.
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 entitys own equity instruments.

Financial Liability
a)

b)

a contractual obligation:
1.
to deliver cash or another financial asset to
another entity; or
2.
To exchange financial assets or financial
liabilities under conditions that are potentially
unfavorable to the entity
a contract that will or may be settled in the entitys
own equity instruments and is:
1.
a non-derivative for which the entity is or
may be obliged to deliver a variable number
of the entitys own equity instruments; or
2.
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 entitys own equity
instruments.

An
An equity
equity instrument
instrument is
is a
a contract
contract that
that evidences
evidences a
a residual
residual interest
interest in
in the
the assets
assets of
of an
an entity
entity after
after deducting
deducting all
all of
of
its
liabilities
and
represents
a
financial
asset
of
the
holder
and
equity
of
the
issuer.
its liabilities and represents a financial asset of the holder and equity of the issuer.

Debtors
Inventory
Provision for taxes

Bank Loan
Prepayments
Dividends payable

CLASSIFY?
Investment in TFCs
Advances from customers
WPPF payable

TFCs issued
Shares issued
Creditors

Compound Instruments

Some financial instruments, called compound instruments, have both a liability and an equity element.
In case this case, IAS 32 requires the component parts to be separated from each other, with each part accounted for and
presented separately according to its substance.
To illustrate, a convertible bond contains two components.
One is a financial liability, the issuers contractual obligation to pay cash (principal and interest on the bond), and
The other is an equity instrument, a call option written to the holder to convert the debt security into common shares.
The separation of components is made at the time the instrument is issued and is not subsequently revised as a result of a
change in interest rates, share price, or other event that changes the likelihood that the conversion option will be exercised.

Illustration
DT plc issues
2,000 convertible bonds at the start of 2008
The bonds have a threeyear term,
Issued at par with a face value of 1,000 per bond.
Interest is payable annually in arrears at 6%.
Each bond is convertible at the holders discretion at any time up to maturity into 250 ordinary common shares of DT plc.
The present value of bond cash flows at a market rate (say 10%) of interest for a similar financial instrument without the equity
conversion option 1,801,052 . This is the liability component.
The difference between the issue proceeds, 2,000,000, and the fair value of the liability component is assigned to the equity
component 198,948.
Dr. Bank
2,000,000
Cr. Financial Liability
1,801,052
Cr. Equity
198,948

Issue Cost

Issue cost relating to issuance of equity shall be


deducted from equity
Transaction cost relating to issuance of liability shall be
deducted from liability
Transaction cost on compound financial instrument will
be allocated on prorata basis of initially recognized
amounts.

Income Statement Classification

Interest, dividends, losses and gains relating to a


financial instrument or a component that is a financial
liability shall be recognized as income or expense in
profit or loss
Distribution to holders of an equity instrument shall be
debited by the entity directly to equity, net of any
related tax benefit.

Effective interest rate method


The effective interest rate is the internal rate of return (IRR) or the level yield to maturity, i.e. the rate that exactly
discounts the estimated future cash flows or receipts through the expected life of the instrument, or where
appropriate, a shorter period, to the net carrying amount at initial recognition.

FVTPL and FV through OCI


Comparison Illustration
Jones buys an investment for $40 million. The transaction costs are $1 million.. At the year end the value of the asset has risen
to $60 million.
Shortly after the year end the asset is sold for $70 million.
How should this be accounted for if the investment is classified as:
Fair value through profit and loss
FV through OCI

Financial Liability at Amortized Cost Illustration


On January 20X1 James issued a deep discount bond with a Rs 50,000 nominal value. The discount was 16% of nominal
value and the costs of issue were Rs 2,000.
Interest of 5% is payable annually in arrears. The bond must be redeemed on 1 January 20X6 at a premium of Rs
4,611.
The effective rate of interest is 12% p.a.
Required:
How will this be reported in financial statements of James over the period to redemption.

Financial Asset Debt Instrument


On 1 January 20X8, Charlton purchased $6m 3.5% redeemable debt. The transaction costs amounted to $120,000. The
debt is redeemable on 31 December 20Y3 at a premium of 30%. Effective interest rate is 7.25%
What investment income should be recorded each year in respect of the debt instrument?

Recognition of Financial Asset and Financial Liability


An entity shall recognise a financial asset or a financial liability in its statement of financial position when, and only
when, the entity becomes party to the contractual provisions of the instrument.
When an entity first recognises a financial asset/financial liability, it shall classify it as discussed earlier and measure it
accordingly.

Regular Way Contracts

Contracts to buy or sell financial assets (for example, contracts to buy securities on an exchange) will have standard
delivery terms prescribed by the exchange. For example, transactions of securities may be required by the exchange
days to be settled three after the trade date a trade taking place today must be paid for (if purchased) or delivered (if
sold) three businesses days from the trade date. For example a trade executed on 11 May settles on 14 May. This kind
of settlement is known as regular way settlement.

The fixed price commitment between trade date and settlement date is a forward contract that meets the definition of
a derivative. However, because of the short duration of the commitment, such a contract is not recognized as a
derivative financial instrument under IFRS 9.

The standard permits either trade date accounting or settlement date accounting for regularway purchases or
sales of a financial asset
Trade date accounting and settlement date accounting refer to methods of recognizing an asset acquired (and
any associated liability incurred) and derecognizing an asset sold (and any associated receivable recognized).
The method used must be applied consistently for all purchases and sales of financial assets that belong to the
same category of financial assets, as defined in IFRS 9.
The choice of method is an accounting policy.

Purchase of Financial Asset


On 29 December 20X1, an entity commits itself to purchase a financial asset for CU1,000, which is its fair value on
commitment (trade) date. Transaction costs are immaterial. On 31 December 20X1 (financial year-end) and on 4 January
20X2 (settlement date) the fair value of the asset is CU1,002 and CU1,003, respectively.

Sale of Financial Asset


On 29 December 20X2 (trade date) an entity enters into a contract to sell a financial asset for its current fair value of
CU1,010. The asset was acquired one year earlier for CU1,000 and its amortized cost is CU1,000. On 31 December 20X2
(financial year-end), the fair value of the asset is CU1,012. On 4 January 20X3 (settlement date), the fair value is CU1,013.

IMPAIRMENT OF FINANCIAL ASSET

Impairment of Financial
Asset

At Fair value

At Amortized cost

Not required
separately FV
Gain/Loss to be
calculated only

Carrying Value
Less: PV of revised cash
flows
using
original
effective interest rate

Example
Included in the financial assets of Traveler is a ten-year 7% loan. At 30 November 2011, the borrower was in financial
difficulties and its credit rating had been downgraded. Traveler has adopted IFRS 9 Financial Instruments and the loan
asset is currently held at amortized cost of $29 million. Traveler now wishes to value the loan at fair value using current
market interest rates. Traveler has agreed for the loan to be restructured; there will only be three more annual
payments of $8 million starting in one years time. Current market interest rates are 8%, the original effective interest
rate is 67% and the effective interest rate under the revised payment schedule is 63%.
What amount would be reported in SFP as at 30-Nov-2011 and what amount would be charged as impairment (if any).

Derecognition of Financial Asset


The basic premise for the derecognition model in IFRS 9 is to determine whether the asset under consideration for
derecognition is:

an asset in its entirety or

specifically identified cash flows from an asset (or a group of similar financial assets) or

a fully proportionate (pro rata) share of the cash flows from an asset (or a group of similar financial assets). or

a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or a group of
similar financial assets)
Once the asset under consideration for derecognition has been determined, an assessment is made as to whether the
asset has been transferred, and if so, whether the transfer of that asset is subsequently eligible for derecognition.
An asset is transferred if either the entity has transferred the contractual rights to receive the cash flows, or the entity
has retained the contractual rights to receive the cash flows from the asset, but has assumed a contractual obligation
to pass those cash flows on under an arrangement that meets the following three conditions:

the entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts on the
original asset

the entity is prohibited from selling or pledging the original asset (other than as security to the eventual
recipient),

the entity has an obligation to remit those cash flows without material delay
Once an entity has determined that the asset has been transferred, it then determines whether or not it has
transferred substantially all of the risks and rewards of ownership of the asset. If substantially all the risks and rewards
have been transferred, the asset is derecognised. If substantially all the risks and rewards have been retained,
derecognition of the asset is precluded.
If the entity has neither retained nor transferred substantially all of the risks and rewards of the asset, then the entity
must
assess whether it has relinquished control of the asset or not. If the entity does not control the asset then
Example
derecognition
is appropriate;
however
if thefrom
entity
has Itretained
asset,20X7.
then At
the31entity
continues
Bell buys an investment
for trading
purposes
Book.
cost $10control
million of
at the
1 January
December
20X7,to
recognise
the
asset
to
the
extent
to
which
it
has
a
continuing
involvement
in
the
asset.
the investment had a fair value of $30 million. On 1 June 20X8 Bell sold the investment to Candle for its market value
of $100 million.
1. How should this be accounted for?
2. Would the answer have been different if Bells purchase contract had contained a put option giving Bell the power
to sell the investment back to Book at market value on 31 December 20X8?
3. Would the answer have been different if Bells sale contract had provided Bell with a call option and Candle with a
put option over the investment, each at a price of $105 million over the next 12 months?

Summer 2012
Zee Power Limited (ZPL) has been facing short term liquidity issues during the financial year ended on 31 December
2011. As a result, the following transactions were undertaken:
i

On 27 December 2011, ZPL sold its investment in listed Term Finance Certificates (TFCs) to Vee Investment
Company Limited with an agreement to buy them back in 10 days. Relevant details are as follows:

Sale price

10,150,000

Buy back price

10,183,337

Value in ZPLs books as on 27 December 2011

10,144,332

Market price as on 31 December 2011

10,163,125

ZPL intends to hold these TFCs till maturity.

ii

On 1 January 2009, ZPL had obtained a bank loan of Rs. 100 million at 10% per annum. The interest was payable
annually on 31 December and principal amount was repayable in five equal annual installments commencing
from 31 December 2009. On 1 January 2011, the bank agreed to facilitate ZPL as follows:
On 27 December 2011, ZPL sold its investment in listed Term Finance Certificates (TFCs) to Vee Investment
Company Limited with an agreement to buy them back in 10 days. Relevant details are as follows:

Balance amount of the principal would be paid at the end of the loans term i.e. on 31 December
2013.

De recognition of Financial Liabilities


Generally a financial liability is derecognized only when it is relinquished, i.e. when the obligation is:
Discharged
An obligation is discharged if an entity delivers:
Cash
Other financial assets
Equity instruments of entity (IFRIC - 19)
Other goods
Which the counterparty accepts as suitable compensation.
Cancelled
Cancellation of an obligation only occurs through a process of law whereby an
entity is legally released from its primary obligation to pay the creditor.
Expired
An obligation expires due to the passage of time.
Derecognition of
Financial Liability

Extinguishment

Restructuring

Substanti
al change
in terms

Other
than
substantia
l change

>= 10% change in


new PV
(calculated using
new terms) and
CV

< 10% change in


new PV (calculated
using new terms)
and CV

Derecognize old
liability and record
new liability Gain/Loss in PL

Adjust CV of old
liability - Gain/Loss
deferred and
amortized over

Hedge Accounting
IAS 39 permits hedge accounting under certain circumstances provided that the hedging relationship is:

formally designated and documented, including the entity's risk management objective and strategy for undertaking the
hedge, identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the entity
will assess the hedging instrument's effectiveness; and

expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk as
designated and documented, and effectiveness can be reliably measured.

Hedging Instruments
All derivative contracts with an external counterparty may be designated as hedging instruments except for some written
options.
An external non-derivative financial asset or liability may not be designated as a hedging instrument except as a hedge of
foreign currency risk.
A proportion of the derivative may be designated as the hedging instrument. Generally, specific cash flows inherent in a
derivative cannot be designated in a hedge relationship while other cash flows are excluded. However, the intrinsic value and
the time value of an option contract may be separated, with only the intrinsic value being designated. Similarly, the interest
element and the spot price of a forward can also be separated,
the spot price being the designated risk.
Hedgedwith
Items
A hedged item can be:
a single recognized asset or liability, firm commitment, highly probable transaction, or a net investment in a foreign
operation;
a group of assets, liabilities, firm commitments, highly probable forecast transactions, or net investments in foreign
operations with similar risk characteristics;
a held-to-maturity investment for foreign currency or credit risk (but not for interest risk or prepayment risk);
a portion of the cash flows or fair value of a financial asset or financial liability; or
a non-financial item for foreign currency risk only or the risk of changes in fair value of the entire item.
in a portfolio hedge of interest rate risk (Macro Hedge) only, a portion of the portfolio of financial assets or financial liabilities
that share the risk being hedged.

Hedge Effectiveness
To qualify for hedge accounting at the inception of a hedge and, at a minimum, at each reporting date, the changes in the fair
value or cash flows of the hedged item attributable to the hedged risk must be expected to be highly effective in offsetting the
changes in the fair value or cash flows of the hedging instrument on a prospective basis, and on a retrospective basis where
actual results are within a range of 80% to 125%.
All hedge ineffectiveness is recognized immediately in the income statement (including ineffectiveness within
the 80% to 125% window).

Discontinuation of Hedge
Accounting

Hedge accounting must be discontinued prospectively if:

the hedging instrument expires or is sold, terminated, or exercised;


the hedge no longer meets the hedge accounting criteria - for example it is no longer effective;
for cash flow hedges the forecast transaction is no longer expected to occur; or
the entity revokes the hedge designation.

If hedge accounting ceases for a cash flow hedge relationship because the forecast transaction is no longer expected to occur, gains
and losses deferred in equity must be taken to the income statement immediately. If the transaction is still expected to occur and the
hedge relationship ceases, the amounts accumulated in equity will be retained in equity until the hedged item affects profit or loss.

Example 1 (Cash Flow Hedge)


A company trades in GBP. It expects to purchase a piece of plant for 1 million euros in one year from 1 May 20X6. In order to offset
the risk of increases in the euro rate, the company enters into a forward contract to purchase 1 million euros in 1 year for a fixed
amount (GBP 650,000). The forward contract is designated as a cash flow hedge. At inception, the forward contract has a fair value
of zero.
At the year end of 31 October 20X6, the euro has appreciated and the value of 1 million euros is GBP 660,000. The machine will still
cost 1 million euros so the company concludes that the hedge is 100% effective. Thus the entire change in the fair value of the
hedging instrument is recognised directly in reserves.

Example 2 Fair Value Hedge


A company purchases an equity instrument for $1 million. The instrument is not held for trading and company designated it to be
measured at fair value with changes to be recognised through other comprehensive income. The company is exposed to a price risk
of the decline in the fair value of the instrument if the market behavior changes.
The company purchases put options in order to offset the risk of a decline in fair value. Any decline in the fair value of the instrument
should be offset by opposite increases in the fair value of the derivative instrument.
Assuming market prices of shares fall to $960,000. The instrument is classified as FV changes in OCI therefore the decrease in fair
value would normally be recorded directly in reserves.
However, since the instrument is a hedged item in a fair value hedge, this change in fair value of the instrument will be recognised in
profit or loss, if hedge is effective.
At the same time, the company determines that the fair value of the put options has increased by $. 40,000. Since the swap is a
derivative, it is measured at fair value with changes in fair value recognised in profit or loss. The changes in fair value of the hedged
item and the hedging instrument exactly offset each other: the hedge is 100% effective and the net effect on profit or loss is zero.

PAST PAPER ANALYSIS


TOPICS

Sum Winte Sum Winter Sum Winter Sum Winter Sum Winter Sum
2014 r 2013 2013 2012 2012 2011 2011 2010 2010 2009 2009

Measurement of Financial
Asset
Q (2)
Measurement of Financial
Liability

Compound Financial
Instrument
Q (1)
Derecognition of Financial
Asset

Extinguishment /
Rescheduling of Financial
Liability

Impairment of Financial Asset Q (3)(b)


Regular way purchase/sale

Hedging

Q (4) ii

Q (2) b

Q (6)

Q (2)

(7)

Q (4) i

Q (5)

Q (2) a

Q (2)

Not
tested

THANK YOU AND BEST OF LUCK

Not
tested

Not
tested