Financial instruments (IFRS 9)
Company A | Company B | |
Financial asset | Financial liability, or equity | |
Purchase shares in co. B | → | Issues shares |
Purchase co. B debt | → | Issues debt |
Sells goods to B | → | Buys good from A |
1 Financial assets
1.1 Initial measurement
Initially recognise at fair value including transaction costs, unless classified as fair value through profit or loss
1.2 Subsequent measurement
Equity instruments
Fair value through profit or loss (default)
Transaction costs are recognised immediately through profit or loss
Re-measure to fair value at the reporting date, with gains or losses through profit or loss
Fair value through other comprehensive income
If there is a strategic intent to hold the asset the option to hold at fair value through other comprehensive income is available. Re-measure to fair value at reporting date, with gains or losses through other comprehensive income.
Debt instruments
Amortised cost
A financial asset is measured at amortised cost if it fulfils both of the following tests:
Business model test – intent to hold the asset until its maturity date; and,
Contractual cash flow test – contractual cash receipts on holding the asset.
Fair value through other comprehensive income
The investment in debt can be classified as FVTOCI if the objective of the business model is to instead collect the cash receipts and sell the financial asset.
1.3 Derecognition
Financial assets are derecognised when sold, with gains or losses on disposal through profit or loss. Gains or losses previously recognised through other comprehensive income are transferred to retained earnings through the statement of changes in equity.
Financial assets
Norman has the following financial assets during the financial year.
Norman bought 100,000 shares in a listed entity on 1 November 2015. Each share cost $5 to purchase and a fee of $0.25 per share was paid as commission to a broker. The fair value of each share at 31 December 2015 was $3.50.
Norman bought 200,000 shares in a listed entity on 1 March 2015 for $500,000, incurring transaction costs of £40,000. Norman acquired the shares as part of a long term strategy to realise the gains in the future. The fair value of the shares was £620,000 at 31 December. The shares were subsequently sold for $650,000 on 31 January 2016.
Norman bought 10,000 debentures at a 2% discount on the par value of $100. The debentures are redeemable in four years’ time at a premium of 5%. The coupon rate attached to the debentures is 4%. The effective rate of interest on the debenture is 5.73%.
Explain how each of the above financial assets will be accounted for in the financial statements.
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2 Financial liabilities
2.1 Initial measurement
Initially recognise at fair value less transaction costs (‘net proceeds’)
2.2 Subsequent measurement
Amortised cost
Fair value though profit or loss
2.3 Derecognition
Financial liabilities are derecognised when they have been paid in full or transferred to another party.
Financial liabilities
Norma issues 20,000 redeemable debentures at their $100 par value, incurring issue costs of $100,000. The debentures are redeemable at a 5% premium in 4 years’ time and carry a coupon rate of 2%. The effective rate on the debenture is 4.58%.
Calculate the amounts to be shown in the statement of financial position and statement of profit or loss for each of the four years of the debenture.
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3 Convertible debentures
If a convertible instrument is issued, the economic substance is a combination of equity and liability and is accounted for using split equity accounting.
The liability element is calculated by discounting back the maximum possible amount of cash that will be repaid assuming that the conversion doesn’t take place. The discount rate to be used is that of the interest rate on similar debt without and conversion option.
The equity element is the difference between the proceeds on issue and the initial liability element.
The liability element is subsequently measured at amortised cost, using the interest rate on similar debt without the conversion option as the effective rate. The equity element is not subsequently changed.
The split is done once, at issue, and the equity element is then left alone. If a question tells you the whole of the proceeds has already been credited to equity, or to a reserve, the entry required is the correcting one — moving the liability element out of equity and into financial liabilities — and not the initial recognition entry written out again. Getting that the wrong way round moves debt and equity in opposite directions and takes any gearing calculation with it.
Convertible debentures
Alice issued one million 4% convertible debentures at the start of the accounting year at par value of $100 million.
The rate of interest on similar debt without the conversion option is 6%.
Explain how Alice should account for the convertible debenture in its financial statements for each of the three years.
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4 Disclosure (IFRS 7)
Financial instruments, particularly derivatives, often require little initial investment, though may result in substantial losses or gains and as such stakeholders need to be informed of their existence. The objective of IFRS7 is to allow users of the accounts to evaluate:
The significance of the financial instruments for the entity’s financial position and performance
The nature and extent of risks arising from financial instruments
The management of the risks arising from financial instruments
Nature and extent of financial risks
Financial risk arising from the use of financial instruments can be defined as:
Credit risk
Liquidity risk
Market risk
Disclosures with regards to these risks need to be both qualitative and quantitative.
Financial instruments (IFRS 9)
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