IAS 32 and IFRS 9 Financial instruments
A financial instrument is a contract that gives rise to a financial asset in one entity and a financial liability or equity instrument in another. Every instrument has two sides, and the two sides are always accounted for as a matching pair.
The contract | Company A holds | Company B holds |
A sells goods to B on credit | A receivable — a financial asset | A payable — a financial liability |
B issues shares, A subscribes | An investment in shares — a financial asset | Share capital — equity |
B issues redeemable debt, A subscribes | An investment in debt — a financial asset | A borrowing — a financial liability |
Two standards divide the work between them:
Standard | What it governs |
IAS 32 Financial Instruments: Presentation | The definitions, and the liability-or-equity question — whether an instrument the issuer has put into the market is a liability or part of equity, and how compound instruments are split between the two. |
IFRS 9 Financial Instruments | Recognition, classification, measurement, impairment and derecognition — when an instrument goes on to the statement of financial position, what it is measured at, and where the gains and losses go. |
IFRS 9 replaced IAS 39, Financial Instruments: Recognition and Measurement. If you meet material — including OT's own current lecture recordings for this chapter — that classifies financial assets as held for trading, held to maturity, loans and receivables and available for sale, you are looking at IAS 39. Those four categories no longer exist. The most consequential change is at the end of the chapter's story: under IAS 39 the gains on an available-for-sale investment were recycled to profit or loss when it was sold, and under IFRS 9 the gains on an equity investment held at fair value through other comprehensive income are never recycled. A third standard, IFRS 7 Financial Instruments: Disclosures, governs the note disclosures and is not examined in detail at this level.
Financial Instruments (IAS 32 and IAS 39): this recording predates the 2027 syllabus. Its first half — definitions, recognition, initial measurement and derecognition — matches this chapter. Its second half sorts financial assets into IAS 39’s four categories, which no longer exist (see the note above). Read them this way:
Held for trading: fair value through profit or loss.
Held to maturity, and loans and receivables: amortised cost, where the business model is to collect the contractual cash flows and those are solely principal and interest (“Classification”).
Available for sale: gone. An equity investment is at fair value through profit or loss unless the irrevocable election for other comprehensive income is made, and gains on an elected investment are never recycled to profit or loss, even on disposal.
1 IAS 32: the definitions
The three definitions
Financial asset — cash; an equity instrument of another entity; a contractual right to receive cash or another financial asset from another entity, or to exchange financial assets or liabilities on potentially favourable terms.
Financial liability — a contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or liabilities on potentially unfavourable terms.
Equity instrument — any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
The word doing the work in the first two is contractual. A tax liability is not a financial liability, because it arises from statute rather than from a contract; inventory is not a financial asset, because it is a right to a thing, not to cash; and prepayments and deferred income are not financial instruments either, because what is coming is goods or services rather than cash.
2 Liability or equity? The IAS 32 classification test
An issuer classifies an instrument, or its component parts, according to the substance of the contractual arrangement — not according to its legal form or its name. One question settles it:
The test
Does the entity have a contractual obligation to deliver cash or another financial asset, and is it able to avoid that obligation? If it cannot avoid it, the instrument is a financial liability. If it can — if any payment is at the entity's own discretion — it is equity.
Instrument | Classification | Why |
Ordinary shares | Equity | A dividend is declared at the entity's discretion and the capital is never repayable. There is no obligation the entity cannot avoid. |
Redeemable preference shares carrying a fixed cumulative dividend | Financial liability | The entity must redeem them, and must pay the dividend. The name says "shares"; the substance is a loan. The "dividend" is presented as a finance cost in profit or loss, not as a distribution. |
Irredeemable preference shares with a discretionary dividend | Equity | Nothing must ever be paid. The dividend, when declared, is a distribution. |
A convertible bond | Both — a compound instrument | There is an obligation to pay cash and an option that gives a residual interest. IAS 32 requires the two to be split; see below. |
The label on the instrument decides nothing. "Preference share" is the classic trap: if it is redeemable at a fixed date for a fixed amount, it is a liability, it sits with borrowings in the statement of financial position, its dividend is a finance cost, and it is part of the gearing ratio. Getting that wrong changes both the gearing and the interest cover a Chapter 21 question is asking you to compute.
Two presentation consequences follow directly from the definition of equity:
The costs of issuing equity are deducted from equity, net of any tax relief, rather than charged to profit or loss. Transaction costs on a liability are absorbed into its carrying amount instead.
Treasury shares — an entity's own shares that it has bought back — are deducted from equity. No gain or loss is ever recognised in profit or loss on the purchase, sale, issue or cancellation of an entity's own equity instruments; you cannot make a profit out of trading in yourself.
3 Financial assets
3.1 Initial measurement
A financial asset is recognised when the entity becomes party to the contractual provisions of the instrument — when the contract is entered into, not when it is settled — and is measured initially at fair value, which is normally what was paid for it.
Classified as | Transaction costs |
Anything other than fair value through profit or loss | Added to the fair value, so the asset goes on at cost including the broker's commission and any fees. |
Fair value through profit or loss (FVTPL) | Expensed immediately to profit or loss. The asset goes on at fair value alone. |
The transaction-cost split is a favourite one-mark question, and the reasoning behind it is worth holding on to: an asset that will be re-measured to fair value through profit or loss at the very next reporting date would have its transaction costs written off within weeks anyway, so IFRS 9 writes them off at once.
3.2 Classification
There are two families of financial asset and they are classified in completely different ways.
Debt instruments — two tests
An investment in debt is classified by asking two questions, and both answers matter:
The business model test. Why is the entity holding the asset — to collect the contractual cash flows, to collect them and also to sell, or to trade?
The contractual cash flow test, usually called the SPPI test. Are the contractual cash flows solely payments of principal and interest on the principal outstanding? Plain interest-bearing debt passes; an instrument whose return is linked to a share price or to commodity prices does not.
Business model | Cash flows are SPPI? | Measured at | Gains and losses |
Hold to collect the contractual cash flows | Yes | Amortised cost | None while held — interest income is recognised using the effective interest rate. |
Hold to collect and to sell | Yes | Fair value through OCI | Interest income to profit or loss; fair value movements to other comprehensive income, and recycled to profit or loss on disposal. |
Anything else — including holding to trade | Yes or no | Fair value through profit or loss | Everything to profit or loss. |
If the SPPI test fails, the asset is at fair value through profit or loss whatever the business model is.
Equity instruments — a default and one election
An investment in another entity's shares has no contractual cash flows, so the two tests cannot be applied to it. The rule is simpler:
Fair value through profit or loss is the default. Everything — the fair value movement each year, and the profit or loss on eventual disposal — goes through profit or loss.
An irrevocable election may be made at initial recognition to present fair value movements in other comprehensive income instead. The election is available only where the investment is not held for trading, it is made investment by investment, and once made it cannot be changed.
The rule this chapter turns on
Where the FVTOCI election has been made for an equity investment, the cumulative gains and losses in other comprehensive income are NEVER recycled to profit or loss — not while the investment is held, and not when it is sold. On disposal the asset is remeasured to fair value, that final movement goes to other comprehensive income too, and the cumulative balance may be transferred within equity to retained earnings. Nothing touches profit or loss at any point except the dividends received.
This is the single biggest change from IAS 39, under which an "available for sale" gain was recycled on disposal. Answers written on the old basis report a profit on disposal that no longer exists.
Dividends received on an equity investment are recognised in profit or loss whichever classification applies — the only amount from an FVTOCI equity investment that ever reaches profit or loss.
Two quite different things share the name FVTOCI, and they behave differently at the end. A debt instrument at FVTOCI is recycled on disposal, so a gain on disposal appears in profit or loss. An equity instrument at FVTOCI is never recycled. Read which kind of instrument the question is about before you decide where the gain goes.
3.3 Reclassification
Debt instruments are reclassified only when the entity changes the business model for managing them, which IFRS 9 expects to be very infrequent, and the change is applied prospectively from the start of the next reporting period. Equity instruments are never reclassified, because the FVTOCI election is irrevocable, and financial liabilities are never reclassified either.
3.4 Amortised cost and the effective interest rate
Amortised cost spreads the whole return on a debt instrument — the coupon, any discount on issue and any premium on redemption — evenly over its life, at a single constant rate: the effective interest rate. It is the rate that discounts the estimated future cash flows back to the carrying amount at initial recognition, and in an exam question it is given.
The mechanics are a four-column table, and the same table works for an asset and for a liability:
Column | Asset (the investor) | Liability (the issuer) |
Balance b/f | Carrying amount of the investment | Carrying amount of the borrowing |
Interest at the effective rate | Interest income in profit or loss | Finance cost in profit or loss |
Cash | Coupon received (at the coupon rate on the par value) | Coupon paid (at the coupon rate on the par value) |
Balance c/f | Carried to the next year, and to the statement of financial position | Carried to the next year, and to the statement of financial position |
The two rates are not the same and each does one job. The effective rate is applied to the carrying amount to give the interest in profit or loss. The coupon rate is applied to the par value to give the cash. The difference between them is what rolls the balance up towards the redemption amount, which is why the balance grows even though cash is being paid.
3.5 Impairment: expected credit losses
IFRS 9 requires a loss allowance for expected credit losses on financial assets held at amortised cost and on debt instruments at fair value through other comprehensive income. It is not required for equity investments or for assets at fair value through profit or loss, whose fair value already reflects the risk.
The change of principle matters more at this level than the mechanics. Under IAS 39 an impairment was recognised only once a loss event had occurred — the model was criticised after the financial crisis for recognising losses "too little, too late". IFRS 9 is forward-looking: a loss allowance is recognised from day one, before anything has gone wrong, and is increased if credit risk subsequently increases significantly. For trade receivables a simplified approach is used, under which lifetime expected credit losses are recognised throughout — which is what a provision matrix based on ageing does in practice.
Expected credit losses and hedge accounting are both parts of IFRS 9 that this paper treats at awareness level only: know what they are for and how they differ from the old IAS 39 approach, rather than computing them. The computations you are asked for are the ones worked in this chapter's examples.
3.6 Derecognition
A financial asset is derecognised when the contractual rights to its cash flows expire — a debt investment is repaid — or when the asset is transferred together with substantially all the risks and rewards of ownership, which is what a sale does. What happens to the accumulated gains and losses depends entirely on the classification:
Classification | On disposal |
Amortised cost | Proceeds less carrying amount = gain or loss in profit or loss. |
Debt instrument at FVTOCI | The cumulative amount in other comprehensive income is reclassified to profit or loss — recycled — and appears with the gain or loss on disposal. |
Equity instrument at FVTOCI (elected) | Remeasure to fair value with the movement in other comprehensive income. Nothing is recycled. The cumulative balance may be transferred within equity to retained earnings, through the statement of changes in equity. |
FVTPL | The asset is already carried at fair value, so the disposal simply removes it; any final movement is in profit or loss with everything else. |
Held for trading (FVTPL), Available for sale assets: this recording predates the 2027 syllabus and uses IAS 39’s labels; its examples are not this chapter’s. Carry three things with you.
Held for trading: read fair value through profit or loss; the accounting shown is unchanged.
Available for sale: gone. A long-term equity investment is at fair value through profit or loss unless the election is made; with it, the gain up to disposal also goes to other comprehensive income and there is no profit on disposal (Example 1, item 2).
Held to maturity: read amortised cost; the effective interest table is this chapter’s method.
Financial assets
Norman entered into the following transactions during the year ended 31 December 20X5.
Norman bought 100,000 shares in a listed entity on 1 November 20X5. Each share cost $5 to purchase, and a fee of $0.25 per share was paid as commission to a broker. No election was made in respect of this investment. The fair value of each share at 31 December 20X5 was $3.50.
Norman bought 200,000 shares in a listed entity on 1 March 20X5 for $500,000, incurring transaction costs of $40,000. Norman acquired the shares as part of a long-term strategy, does not hold them for trading, and made the irrevocable election available to it at initial recognition. The fair value of the shares was $620,000 at 31 December 20X5. The shares were subsequently sold for $650,000 on 31 January 20X6.
Norman bought 10,000 debentures at a 2% discount on the par value of $100 each. The debentures are redeemable in four years' time at a premium of 5%. The coupon rate attached to the debentures is 4%, and the effective rate of interest is 5.73%. Norman intends to hold the debentures until they are redeemed.
Explain how each of the above financial assets will be accounted for in the financial statements.
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Financial Liabilities: the recording describes liabilities as “held for trading” or “held to maturity”. Under IFRS 9 a financial liability is at amortised cost unless it is held for trading, such as a derivative with a negative value, or designated at fair value through profit or loss; “held to maturity” never applied to liabilities. The rest stands: initial measurement at net proceeds, and the amortised cost table, worked on its own example rather than Example 2.
4 Financial liabilities
The same instrument seen from the issuer's side, and the treatment is close to the mirror image — with one deliberate difference at initial recognition.
Financial asset | Financial liability | |
Initial measurement | Fair value plus transaction costs (unless FVTPL, when they are expensed). | Fair value less transaction costs — in other words the net proceeds of the issue. |
Subsequent measurement | Amortised cost, FVTOCI or FVTPL, per the classification above. | Amortised cost, unless the liability is held for trading or has been designated at FVTPL on initial recognition. |
In profit or loss | Interest income | Finance cost |
Derecognition | When the rights to the cash flows expire or the asset is transferred. | When the obligation is discharged, cancelled or expires — in practice, when it is paid off. |
Transaction costs move in opposite directions on the two sides, and for the same reason: they always reduce what you are left with. On an asset you paid the costs on top of the price, so the asset costs you more — add. On a liability the costs came out of what you raised, so you received less — deduct. Both end up in profit or loss over the life of the instrument, through the effective interest rate.
For awareness only, and beyond what this paper computes: where a financial liability is designated at fair value through profit or loss, the part of the fair value movement caused by a change in the entity's own credit risk is presented in other comprehensive income rather than in profit or loss — otherwise a company would report a profit as its own creditworthiness deteriorated.
Financial liabilities
Larkin 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 four years' time and carry a coupon rate of 2%. The effective rate of interest on the debentures is 4.58%.
Calculate the amounts to be shown in the statement of financial position and the statement of profit or loss for each of the four years of the debenture.
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Convertible Instruments: the surrounding classification framework this recording refers to — IAS 39’s four categories — is retired, and this chapter’s IFRS 9 classification governs. No IFRS 18 content is present, and the worked examples differ from the printed ones. Convertibles are IAS 32, which has not changed.
5 Compound instruments: convertible debt
A convertible bond gives the holder the choice, at redemption, between taking cash and taking shares. In substance the issuer has sold two things at once: an obligation to pay cash, and an option over its own shares. IAS 32 requires the two to be split and presented separately.
Measure the liability component first, as the present value of the cash flows the issuer would have to pay assuming nobody converts — the coupons and the redemption amount — discounted at the interest rate on similar debt without a conversion option.
The equity component is the residual: the proceeds of the issue less the liability component. It is not measured directly.
Subsequently the liability is measured at amortised cost, using that same rate as the effective rate. The equity component is never remeasured.
Equity component = Proceeds of the issue − Present value of the liability
The logic of the residual is the definition of equity itself: equity is what is left after deducting liabilities, so the option is measured as the amount investors were evidently willing to pay over and above the value of a plain loan, in exchange for the right to convert.
Two discount-rate traps. Use the rate on similar debt without the conversion option, not the convertible's own coupon rate — the coupon is low precisely because the conversion right is worth something, so discounting at it would value the liability at par and leave no equity component at all. And discount the maximum cash the issuer could have to pay: you are valuing the debt as if the option did not exist.
Convertible debentures
Alice issued one million 4% convertible debentures at the start of the accounting year, at their par value of $100 million in total. They are redeemable at par in three years' time, or convertible into ordinary shares at that date at the holder's option.
The rate of interest on similar debt without the conversion option is 6%. Discount factors at 6% are: year 1 0.943, year 2 0.890, year 3 0.840.
Explain how Alice should account for the convertible debentures in its financial statements for each of the three years.
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Derivatives: the same notice applies — the IAS 39 classification framework the recording refers to is retired and this chapter’s IFRS 9 classification governs, no IFRS 18 content is present, and the worked examples differ from the printed ones. Derivatives are measured at fair value through profit or loss under IFRS 9 exactly as they were under IAS 39.
6 Derivatives
A derivative is a financial instrument with all three of the following characteristics:
its value changes in response to a change in a specified interest rate, exchange rate, price, rating, index or other variable;
it requires no initial net investment, or one that is smaller than would be required for other contracts expected to respond similarly to changes in the variable;
it is settled at a future date.
Forward contracts, futures, options and swaps are the common forms. A derivative is recognised as an asset when it is favourable to the entity and as a liability when it is unfavourable, and it is measured at fair value through profit or loss both initially and subsequently.
Why a derivative starts at nil
A forward contract entered into at today's forward rate has a fair value of nil on the day it is signed: anyone could enter into the same contract on the same terms, so the right it confers is worth nothing. It acquires a value only as the underlying rate moves away from the contracted rate. That is what makes the second characteristic — no initial net investment — a definition rather than a curiosity: a derivative is a contract that costs nothing to enter and can then be worth a great deal.
Derivatives
On 1 February 20X8 the directors of Wayne decided to enter into a forward foreign exchange contract to buy 12 million Dinar at a forward rate of $1 = 6 Dinar, on 31 May 20X9. Wayne's year end is 31 March.
Relevant forward exchange rates were as follows:
Date | Forward rate |
1 February 20X8 | $1 = 6 Dinar |
31 March 20X8 | $1 = 5.8 Dinar |
31 March 20X9 | $1 = 5.6 Dinar |
Prepare relevant extracts from Wayne's statement of profit or loss and statement of financial position to reflect the forward foreign exchange contract at 31 March 20X9, with comparatives. Ignore discounting when measuring the derivative.
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7 Where this appears under IFRS 18
IFRS 18 Presentation and Disclosure in Financial Statements replaces IAS 1 for accounting periods beginning on or after 1 January 2027. Recognition and measurement are unchanged — financial instruments are still IFRS 9 and IAS 32, and no amount in this chapter moves.
What changes is where the amounts sit. The financing category holds income and expenses on liabilities that arise from transactions involving only the raising of finance, which is exactly what the debentures in Examples 2 and 3 are: their finance costs are financing items, as are the "dividends" on redeemable preference shares classified as liabilities. The investing category holds income and expenses from cash and cash equivalents and from other assets that generate a return individually and largely independently of the entity's other resources — which is where investment income of the kind in Example 1 falls. Both sit below operating profit, and the investing category sits above the second required subtotal, *profit before financing and income taxes*, while the financing category sits below it.
The category boundaries are taught in the group chapters, and a classification question is quick marks: park each item in its category first, then build the subtotals. The one to watch in this chapter is the redeemable preference share — because IAS 32 makes it a liability, its dividend is a finance cost, and under IFRS 18 that finance cost is a financing item. Treating it as a distribution puts it in the wrong statement altogether.
IAS 32 defines the three terms and answers one question: is an instrument the entity has issued a liability or equity? It is a liability if there is a contractual obligation to deliver cash that the entity cannot avoid — so redeemable preference shares are debt and their dividend is a finance cost — and a convertible bond is split, the liability measured as the present value of the cash flows at the rate on similar non-convertible debt and the equity component taken as the residual. IFRS 9 classifies and measures. Debt instruments pass through two tests — the business model, and whether the cash flows are solely payments of principal and interest — giving amortised cost, fair value through OCI, or fair value through profit or loss. Equity instruments are at fair value through profit or loss unless an irrevocable election made at initial recognition puts fair value movements in OCI, where they stay for ever: an equity FVTOCI gain is never recycled, which is the single biggest break from IAS 39. Transaction costs are added to a financial asset and deducted from a financial liability, except on an FVTPL asset where they are expensed at once. Amortised cost runs the effective rate on the carrying amount and the coupon rate on the par value. Derivatives are always at fair value through profit or loss, and start life worth nothing.
8 Test your knowledge
IAS 32 and IFRS 9 Financial instruments
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