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13 RELEVANT TO ACCA QUALIFICATION PAPERS F7 AND P2 What is a financial instrument? Let us start by looking at the definition of a financial instrument, which is that a financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. With references to assets, liabilities and equity instruments, the statement of financial position immediately comes to mind. Further, the definition describes financial instruments as contracts, and therefore in essence financial assets, financial liabilities and equity instruments are going to be pieces of paper. For example, when an invoice is issued on the sale of goods on credit, the entity that has sold the goods has a financial asset the receivable while the buyer has to account for a financial liability the payable. Another example is when an entity raises finance by issuing equity shares. The entity that subscribes to the shares has a financial asset an investment while the issuer of the shares who raised finance has to account for an equity instrument equity share capital. A third example is when an entity raises finance by issuing bonds (debentures). The entity that subscribes to the bonds ie lends the money has a financial asset an investment while the issuer of the bonds ie the borrower who has raised the finance has to account for the bonds as a financial liability. So when we talk about accounting for financial instruments, in simple terms what we are really talking about is how we account for investments in shares, investments in bonds and receivables (financial assets), how we account for trade payables and long-term loans (financial liabilities) and how we account for equity share capital (equity instruments). (Note: financial instruments do also include derivatives, but this will not be discussed in this article.) In considering the rules as to how to account for financial instruments there are various issues around classification, initial measurement and subsequent measurement. This article will consider the accounting for equity instruments and financial liabilities. Both arise when the entity raises finance ie receives cash in return for issuing a financial instrument. A subsequent article will consider the accounting for financial assets. Distinguishing between debt and equity For an entity that is raising finance it is important that the instrument is correctly classified as either a financial liability (debt) or an equity instrument (shares). This distinction is so important as it will directly affect the calculation of the gearing ratio, a key measure that the users of the financial statements use to assess the financial risk of the entity. The distinction will also impact on the measurement of profit as the finance costs associated with financial liabilities will be charged to the income 2012 ACCA

14 2 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 statement, thus reducing the reported profit of the entity, while the dividends paid on equity shares are an appropriation of profit rather than an expense. When raising finance the instrument issued will be a financial liability, as opposed to being an equity instrument, where it contains an obligation to repay. Thus, the issue of a bond (debenture) creates a financial liability as the monies received will have to be repaid, while the issue of ordinary shares will create an equity instrument. In a formal sense an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. It is possible that a single instrument is issued that contains both debt and equity elements. An example of this is a convertible bond ie where the bond contains an embedded derivative in the form of an option to convert to shares rather than be repaid in cash. The accounting for this compound financial instrument will be considered in a subsequent article. Equity instruments Equity instruments are initially measured at fair value less any issue costs. In many legal jurisdictions when equity shares are issued they are recorded at a nominal value, with the excess consideration received recorded in a share premium account and the issue costs being written off against the share premium. Example 1: Accounting for the issue of equity Dravid issues 10,000 $1 ordinary shares for cash consideration of $2.50 each. Issue costs are $1,000. Required Explain and illustrate how the issue of shares is accounted for in the financial statements of Dravid. Solution The entity has raised finance (received cash) by issuing financial instruments. Ordinary shares have been issued, thus the 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. The issue costs are written off against share premium. The issue of ordinary shares can thus be summed up in the following journal entry. Dr Cash $24,000 The gross cash received is 10,000 x $2.5 = $25,000 but the issue costs of $1,000 have to be paid Cr Equity Share Capital Cr Share Premium $10,000 The 10,000 shares issued are recorded at their nominal value of $1 each $14,000 The excess consideration received of $15,000 ($1.50 x 10,000) is recorded in share premium but net of the issue costs of $1, ACCA

15 3 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 Equity instruments are not remeasured. Any change in the fair value of the shares is not recognised by the entity, as the gain or loss is experienced by the investor, the owner of the shares. Equity dividends are paid at the discretion of the entity and are accounted for as reduction in the retained earnings, so have no effect on the carrying value of the equity instruments. As an aside, if the shares being issued were redeemable, then the shares would be classified as financial liabilities (debt) as the issuer would be obliged to repay back the monies at some stage in the future. Financial liabilities A financial instrument will be a financial liability, as opposed to being an equity instrument, where it contains an obligation to repay. Financial liabilities are then classified and accounted for as either fair value through profit or loss (FVTPL) or at amortised cost. Financial liabilities at amortised cost The default position is, and the majority of financial liabilities are, classified and accounted for at amortised cost. Financial liabilities that are classified as amortised cost are initially measured at fair value minus any transaction costs. Accounting for a financial liability at amortised cost means that the liability's effective rate of interest is charged as a finance cost to the income statement (not the interest paid in cash) and changes in market rates of interest are ignored ie the liability is not revalued at the reporting date. In simple terms this means that each year the liability will increase with the finance cost charged to the income statement and decrease by the cash repaid. Example 2: Accounting for a financial liability at amortised cost Laxman raises finance by issuing zero coupon bonds at par on the first day of the current accounting period with a nominal value of $10,000. The bonds will be redeemed after two years at a premium of $1,449. The effective rate of interest is 7%. Required Explain and illustrate how the loan is accounted for in the financial statements of Laxman. Solution Laxman is receiving cash that it is obliged to repay, so this financial instrument is classified as a financial liability. There is no suggestion that the liability is being held for trading purposes nor that the option to have it classified as FVTPL has been made, so, as is perfectly normal, the liability will be classified and accounted for at amortised cost and initially measured at fair value less the transaction costs. The bonds are being issued at par, so there is neither a premium or discount on issue. Thus Laxman initially receives $10,000. There are no transaction costs and, if there were, they would be deducted. Thus, the liability is initially recognised at $10, ACCA

16 4 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 In applying amortised cost, the finance cost to be charged to the income statement is calculated by applying the effective rate of interest (in this example 7%) to the opening balance of the liability each year. The finance cost will increase the liability. The bond is a zero coupon bond meaning that no actual interest is paid during the period of the bond. Even though no interest is paid there will still be a finance cost in borrowing this money. The premium paid on redemption of $1,449 represents the finance cost. The finance cost is recognised as an expense in the income statement over the period of the loan. It would be inappropriate to spread the cost evenly as this would be ignoring the compound nature of finance costs, thus the effective rate of interest is given. In the final year there is a single cash payment that wholly discharges the obligation. The workings for the liability being accounted for at amortised cost can be summarised and presented as follows. Opening balance Plus income statement finance on the opening balance Less the cash paid Closing balance, being the liability on the statement of financial position Year 1 $10,000 $700 (Nil) $10,700 Year 2 $10,700 $749 ($11,449) Nil Accounting for financial liabilities is regularly examined in both Paper F7 and Paper P2 so let's have a look at another, slightly more complex example. Example 3: Accounting for a financial liability at amortised cost Broad raises finance by issuing $20,000 6% four-year loan notes on the first day of the current accounting period. The loan notes are issued at a discount of 10%, and will be redeemed after three years at a premium of $1,015. The effective rate of interest is 12%. The issue costs were $1,000. Required Explain and illustrate how the loan is accounted for in the financial statements of Broad. Solution Broad is receiving cash that is obliged to repay, so this financial instrument is classified as a financial liability. Again, as is perfectly normal, the liability will be classified and accounted for at amortised cost and, thus, initially measured at the fair value of consideration received less the 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 the nominal value less the discount on issue ($20,000 $18,000 x 90%) Less the transaction costs ($1,000) Initial recognition of the financial liability $17,000 In applying amortised cost, the finance cost to be charged to the income statement is calculated by applying the effective rate of interest (in this example 12%) to the 2012 ACCA

17 5 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 opening balance of the liability each year. The finance cost will increase the liability. The actual cash is paid at the end of the reporting period and is calculated by applying the coupon rate (in this example 6%) to the nominal value of the liability (in this example $20,000). The annual cash payment of $1,200 (6% x $20,000 = $1,200) will reduce the liability. In the final year there is an additional cash payment of $21,015 (the nominal value of $20,000 plus the premium of $1,015), which extinguishes the remaining balance of the liability. The workings for the liability being accounted for at amortised cost can be summarised and presented as follows. Opening balance Plus income statement finance 12% on the opening balance Less the cash paid (6% x 20,000) Closing balance, being the liability on the statement of financial position Year 1 $17,000 $2,040 ($1,200) $17,840 Year 2 $17,840 $2,141 ($1,200) $18,781 Year 3 $18,781 $2,254 ($1,200) $19,835 Year 4 $19,835 $2,380 ($1,200) ($21,015) Nil Total finance costs $8,815 Because the cash paid each year is less than the finance cost, each year the outstanding liability grows and for this reason the finance cost increases year on year as well. The total finance cost charged to income over the period of the loan comprises not only the interest paid, but also the discount on the issue, the premium on redemption and the transaction costs. Interest paid (4 years x $1,200) = $4,800 Discount on issue (10% x $20,000) = $2,000 Premium on redemption $1,015 Issue costs $1,000 Total finance costs $8,815 Financial liabilities at FVTPL Financial liabilities are only classified as FVTPL if they are held for trading or the entity so chooses. This is unusual and only examinable in Paper P2. The option to designate a financial liability as measured at FVTPL will be made if, in doing so, it significantly reduces an accounting mismatch that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases, or if the liability is part or a group of financial liabilities or financial assets and financial liabilities that is managed and its performance is evaluated on a fair value basis, in accordance with an investment strategy. In addition, a financial liability may still be designated as measured at FVTPL when it contains one or more embedded derivatives that would require separation. 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 ACCA

18 6 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 By accounting for a financial liability at FVTPL, the financial liability is also increased by a finance cost and reduced by cash repaid but is then revalued at each reporting date with any gains and losses immediately recognised in the income statement. The measurement of the new fair value at the year end will be its market value or, if not known, the present value of the future cash flows, using the current market interest rates. The interest rate used subsequently to calculate the finance cost will be this new current rate until the next revaluation. Example 4: Accounting for a financial liability at FVTPL On 1 January 2011 Swann issued three year 5% $30,000 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 Explain and illustrate how the loan is accounted for in the financial statements of Swann in the year ended 31 December Solution Swann is receiving cash that is obliged to repay so this financial instrument is classified as a financial liability. The liability is classified at FVTPL so, presumably, it is being held for trading purposes or the option to have it classified as FVTPL has been made. Initial measurement is at the fair value of $30,000 received and, although there are no transaction costs in this example, these would be expensed rather than taken into account in arriving at the initial measurement. With an effective rate of interest and the coupon rate both being 5%, at the end of the accounting period the carrying value of the liability will still be $30,000. This is because the finance cost that will increase the liability is $1,500 (5% x $30,000 the effective rate applied to the opening balance), and the cash paid reducing the liability is also $1,500 (5% x $30,000 the coupon rate applied to the nominal value). 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. Payment due 31 December 2012 (interest only) Payment due 31 December 2013 (the final interest payment and the repayment of the $30,000) Fair value of the liability at 31 December 2011 Cash flow 6% discount factor Present value of the future cash flow $1,500 x = $1,415 $31,500 x = $28,035 $29, ACCA

19 7 ACCOUNTING FOR FINANCIAL INSTRUMENTS JULY 2012 As Swann has classified this liability as FVTPL, it is revalued to $29,450. The reduction of $550 in the carrying value of the liability from $30,000 is regarded as a profit, and this is recognised in the income statement. If, however, the higher discount rate used was not because general interest rates have risen, rather the credit risk of the entity has risen, then the gain is recognised in other comprehensive income. This can all be summarised in the following presentation. Opening balance Plus income statement finance 5% on the opening balance Less the cash paid (5% x 30,000) Carrying value of the liability at the year end Fair value of the liability at the year end Gain to income statement 1/1/2011 $30,000 $1,500 ($1,500) $30,000 $29,450 $550 We can briefly consider the accounting in the remaining two years. The finance charge in the income statement for the year end 31 December 2012 will be the 6% x $29,450 = $1,767, and with the cash payment of $1,500 being made, the carrying value of the liability will be $29,717 ($29,450 plus $1,767 less $1,500) at the year end. If at 31 December 2012 the market rate of interest has fallen to, say, 4%, then the fair value of the liability at the reporting date will be the present value of the last repayment due of $31,500 in one year's time discounted at 4% (ie $31,500 x = $30,288), which in turn means that as the fair value of the liability exceeds the carrying value, a loss of $571 (ie $30,288 less $29,717) arises which is recognised in the income statement. In the final year ending 31 December 2013 the finance cost to the income statement will be 4% x $30,288 = $1,212, increasing the liability to $31,500 before the final cash payment of $31,500 is made, thus extinguishing the liability. As you may know from your financial management studies, and as is demonstrated here, when interest rates rise so the fair value of bonds fall and when interest rates fall then the fair value of bonds rises. The next article will consider the accounting for convertible bonds and financial assets. Tom Clendon FCCA is a senior tutor at Kaplan Financial, London 2012 ACCA

20 TECHNICAL PAGE 48 STUDENT ACCOUNTANT NOVEMBER/DECEMBER 2008 FINANCIAL INSTRUMENTS UNDERSTANDING THE BASICS RELEVANT TO ACCA QUALIFICATION PAPERS F7 AND P2 This article aims to help students better understand accounting standards relating to financial instruments. It deals with the facts and terminology that you will need to know, understand, and be able to apply when accounting for financial instruments. Also included are exercises that will test your understanding. In order to understand accounting for financial instruments, there is some terminology, together with some principles and rules, that you must understand. Let us start by asking some key questions, looking first at the technically correct answer then trying to put it into more everyday language. KEY QUESTION What are The technically A discussion to financial instruments? correct answer help understanding A financial instrument is As you can see from a contract that gives rise the technical definition, to a financial asset of a financial instrument one entity and a financial is a contract, so it liability or equity may be helpful to think instrument of another of a financial instrument entity. A financial asset as a piece of paper as is any asset that is: cash, contracts are normally an equity instrument of written down. We can another entity, or a also see that this piece contractual right to of paper has two effects receive cash or another in two different financial asset from companies. So if we another entity, or to think of an invoice that exchange financial assets my company issues or financial liabilities with following the sale of another entity under goods, then I have a conditions that are receivable (a financial potentially favourable to asset) but the company the entity; or a contract that has bought the that will or may be goods will consider the settled in the entity s same contract/piece own equity instruments of paper/invoice as a and is: financial liability. In a a non-derivative for similar way, if my which the entity is or company is a lender may be obliged to (ie operates like a bank) receive a variable then I have a financial number of the asset the loan but entity s own equity the borrower has a instruments liability to repay the loan. What are a derivative that will Such written loan financial instruments? or may be settled agreements are often other than by the called debentures. A exchange of a fixed third example is when a amount of cash or company issues another financial ordinary shares (more asset for a fixed pieces of paper). If I number of the subscribe to those entity s own equity shares then in my instruments. For this accounts I have a purpose, the entity s financial asset of the own equity investment in the instruments do not shares, but the issuing include instruments company has created an that are themselves equity instrument. contracts for the Thus we should future receipt or consider examples of delivery of the financial instruments entity s own to be: receivables and equity instruments. payables, investments in debentures and loans, A financial liability is any and investments in liability that is a equity and contractual obligation: ordinary shares. to deliver cash or another financial Of course there are asset to another more complex financial entity, or instruments such as to exchange financial options, swaps and assets or financial futures, collectively liabilities with known as derivatives. another entity under These are held either for conditions that speculation (taking a are potentially risk) or for hedging (to unfavourable to the offset an existing risk). entity, or However, hedge a contract that will accounting does not or may be settled in come under the the entity s own heading of equity instruments. basic information.

21 TECHNICAL PAGE 49 LINKED PERFORMANCE OBJECTIVES STUDYING PAPER F7 OR P2? DID YOU KNOW THAT PERFORMANCE OBJECTIVES 10 AND 11 ARE LINKED? When should financial A company should Recognition is the assets and liabilities recognise a financial process of including an be recognised? asset or a financial asset or liability on the liability on its accounts statement of financial when the company position (balance sheet). becomes a party to the To recognise a financial contractual provisions of asset or liability when the instrument, rather you become a party to than when the contract the contract simply is settled. means that when you purchase the shares you show the asset in your accounts, and when you have borrowed the money from the bank you recognise the liability. How are Initially, financial assets All financial assets and financial assets and liabilities should be liabilities should be and liabilities measured at fair value measured at the fair initially measured? (including transaction value of the costs for assets and consideration received liabilities not measured or paid when we enter at fair value through into the contract. In profit or loss). simple terms, this means that if we have purchased an investment for $500 cash, then the asset will be recorded as $500. Transaction costs are generally capitalised just as legal fees would be if we were buying a property. When should financial A company should The derecognition of an assets be derecognised? derecognise a financial asset means that it will asset when either of the no longer be included on following has occurred: the statement of The asset has been financial position sold so that the risks (balance sheet). This and rewards of will normally arise when ownership have the asset is sold. passed away. However, the terminology The contractual of a sale is legal rights to the cash language and what is flow of the financial more important to asset have expired accountants, who have (see Example 5). to show a true and fair view, is the substance of the transaction. Thus we should remember that derecognition involves the passage of the risks and rewards of ownership. When should A financial liability Normally, liabilities financial liabilities should be removed from disappear when they be derecognised? the statement of financial are paid off in the form position (balance sheet) of cash, thus they will when, and only when, it no longer be a claim. is extinguished, that is, Liabilities can also be when the obligation settled by winning a specified in the contract court case or by the is either discharged, issue of shares, eg with cancelled, or expired. convertible loan stock. If there has been an If a creditor is settled for exchange between less than the carrying an existing borrower and value then we have lender of debt a profit instruments with substantially different terms, or there has been a substantial modification of the terms of an existing financial liability, this transaction is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. A gain or loss from extinguishment of the original financial liability is recognised in the income statement. HOW ARE FINANCIAL ASSETS CLASSIFIED AND ACCOUNTED FOR? There are four separate categories of financial assets: Held to maturity investments Available for sale Loans and receivables Fair value through profit or loss. The mnemonic HALF should help you remember this list. Table 1 sets out the relevant information which has to be rote learnt.

22 TECHNICAL PAGE 50 STUDENT ACCOUNTANT NOVEMBER/DECEMBER 2008 TABLE 1: CATEGORIES OF FINANCIAL ASSETS Category Accounting treatment Additional technical points Example Held-to-maturity investments Held-to-maturity investments If an entity sells a held-to-maturity An example of a held-to-maturity are measured at amortised cost. investment other than in insignificant investment is where a company holds These are financial assets with fixed amounts, or as a consequence of a (as an investment) fixed interest or or determinable payments that an See later in this article for an non-recurring, isolated event beyond fixed-term debt/bonds for the whole entity intends (and is able) to hold explanation as to what accounting its control that could not be of its life. to maturity. at amortised cost means. reasonably anticipated, all of its other held-to-maturity investments must be reclassified as available-for-sale for the current and next two financial reporting years. Available-for-sale financial assets Available-for-sale financial assets The cumulative gain or loss that was An example of an available-for-sale are measured at fair value in the recognised in equity is recognised in asset is a long-term investment in This is a default category. statement of financial position income when an available-for-sale equity shares. (balance sheet). financial asset is derecognised, ie it is The name available-for-sale is quite recycled (see Example 2). Any financial asset that cannot be strange as the majority of financial The changes in value are classified into another category is assets categorised here are going to recognised in reserves (other deemed to fall into the be long-term assets. comprehensive income/statement available-for-sale category, ie it is the of recognised gains and losses). default category. Loans and receivables Loans and receivables are Technically, provisions are no longer An example of loans and receivables measured at amortised cost. made for bad and doubtful debts; is simple trade debtors. These are financial assets with fixed instead, receivables are subject to an or determinable payments, originated impairment review and written down or acquired, that are not quoted in to their recoverable amount. an active market, and not held for trading. Financial assets at fair value through Financial assets at fair value through Allowing the company the choice to An example is a derivative that is profit or loss profit or loss are measured at fair designate any financial asset at fair held for speculation purposes. value in the statement of financial value through profit or loss has the These are all derivatives (except those position (balance sheet). effect of reducing comparability For example, this will occur if a designated as hedging instruments) between companies. company with no foreign currency and financial assets acquired or held The changes in value are recognised assets, liabilities or transactions for the purpose of selling in the short in income. enters into a forward foreign currency term, or for which there is a recent contract (a derivative) with a view to pattern of short-term profit taking, are While derivatives are a potentially making a profit on the contract due to held for trading. complex area, remember that there future changes in exchange rates are only two reasons why a company In addition, any financial asset can be would hold them hedging Such derivative contracts can be designated on initial recognition as or speculation. Of course, changes entered into at no cost or at an one to be measured at fair value with in value of financial assets at fair immaterial cost so it is important to fair value changes in profit or loss. value through profit or loss should be have it recognised at fair value at the This is the so-called fair value option. recognised in income, as not only is year end otherwise it would that what their name implies but also be invisible. because they arise from speculation or trading activities.

23 TECHNICAL PAGE 51 HOW ARE FINANCIAL LIABILITIES CLASSIFIED AND ACCOUNTED FOR? Technically, there are two categories of financial liabilities, detailed in Table 2, although the vast majority in reality, and in the exam, will be measured at amortised cost. TABLE 2: CATEGORIES OF FINANCIAL LIABILITY Category Accounting treatment Example Financial liabilities measured at amortised cost Examples include trade This is the These are measured at creditors, loans, and default category. amortised cost. debenture liabilities. Financial liabilities at Financial liabilities at fair value through profit fair value through or loss profit or loss are measured at fair value Like financial assets, in the statement of these are speculative financial position derivatives, and those (balance sheet). The An example is a liabilities that have been changes in value are derivative that is held so designated. recognised in income. for speculation purposes. WHAT EXACTLY IS MEANT BY THE ACCOUNTING TREATMENT AMORTISED COST? Technically, accounting for an asset or liability using amortised cost means that the income statement will reflect the effective rate of interest of the financial asset or liability. The effective rate of interest is the true interest rate reflecting the market rate. It is always given in accounting exams though using financial management techniques can sometimes be calculated as the IRR. The effective rate of interest may or may not be the same as the amount of the annual cash flow associated with the instrument. Let s take a step back and remember that if we account for land at cost then this means that the carrying value will not change year on year as the historic cost never changes. If we account for plant then, as it has a limited life, we can account for it using depreciated cost. This would mean that although the asset is never revalued, the carrying value would reduce each year to reflect the depreciation being charged. If we account for a liability using amortised cost then, again, it has not been revalued but it will go up each year by the effective rate of interest, charged as an expense (DR Income Interest payable CR Liability), and reduced by the cash actually paid over (DR Liability CR Cash). If more cash is paid than interest charged the net effect is that at the year end the liability will have been reduced over the period. This is what happens with finance lease obligations. EXAMPLE 1 Accounting for a liability using amortised cost If a company borrows $400 over two years and the effective rate of interest is 10% then there has to be a finance charge to income of $40 in the first year. Let us assume that the lender has agreed to be paid interest in arrears at the rate of 5%, which means that the annual cash flow will be (5% x 400) = 20. Under the terms of the loan there will be a premium on redemption of $42. At the end of the first year, the liability will have grown to $420, and, of course, after two years, the liability will be extinguished by the final payment (see Example 3). The following working is a summary of the accounting treatment using amortised cost: Opening Income statement Cash flow Year end effective interest rate balance of 10% Year (20) 420 Year (20) 442 (442) The same working can be done from the perspective of the lender, as they will also account for the loan that they have made using amortised cost (having classified the loan as an asset in loans and receivables ). Being an asset, the lender is earning interest, recognised in the income statement as income, and receiving cash. ANNUAL IMPAIRMENT REVIEW At each year end, all companies are required to assess whether there is any objective evidence of impairment of financial assets. If any such evidence exists, the entity is required to undertake a detailed impairment calculation to determine whether an impairment loss should be recognised (see Example 4). DEBT OR EQUITY When a company wishes to raise finance, it can do so by issuing debt or equity. The classification of the instruments issued into one of these two categories is important, as it has a direct impact on the debt to equity ratio of the company (the gearing ratio) and therefore on the perception of the company s risk. The fundamental principle to be applied is that a financial instrument issued by a company should be classified as either a debt or an equity instrument according to the substance of the contract, not its legal form. The company must make the decision at the time the instrument is initially recognised. A debt is defined in terms of there being an obligation to transfer cash or similar, and an equity instrument if there is no such obligation. Accordingly, it should be noted that redeemable preference shares and cumulative preference shares are both examples of instruments that are, in substance, debts and should be accounted for as such, ie as a liability measured at amortised cost, with the effective rate of interest being charged to income as an expense. Debt and equity The issue of convertible loan stock is, however, an example of a compound financial instrument as, from the issuer s perspective, the one piece of paper contains both a liability and an equity component. Convertible loan stock will contain an embedded derivative, ie an option that allows the holder to be repaid in shares rather than cash. With compound financial instruments, it is necessary to split the debt and equity elements at inception. The debt element is measured at the present value of the future cash flow, and the equity element (the value of the option) can be measured as the balancing figure (see Example 6). EXAMPLE 2 Available-for-sale: Tobago Tobago purchased an investment in shares for $10,000. Transaction costs incurred were an additional $500. At the year end, the fair value of the investment had risen to $15,000. Shortly after the year end, the asset was sold for $16,000. Requirement: Explain the accounting treatment on the basis that the investment is classified as available-for-sale. The solution can be found at the end of the article. EXAMPLE 3 Amortised cost: Ryland Ryland has raised finance by issuing $200,000 4% debentures at par that

24 TECHNICAL PAGE 52 STUDENT ACCOUNTANT NOVEMBER/DECEMBER 2008 will be redeemed in two-years time at a premium of $16,640. The effective rate of interest is 8%. Requirement: Discuss the accounting implications of this financial instrument over its two-year life. The solution can be found at the end of the article. EXAMPLE 4 Impairment and amortised cost: Lagos Lagos made a three-year loan of $10,000 on 1 January 2005 to a customer, requiring that the customer pay a simple interest rate of 10% on an annual basis, and that the principal sum of $10,000 be repaid at the end of three years. The effective rate of interest is also 10%. At the current year end of 31 December 2006, all due payments have been received as expected, but the borrower is in financial difficulty. It is now estimated that the only future cash flow will be $5,000 in one-year s time, ie three years after the date of the original advance. Requirement: Discuss the accounting implications of this financial instrument over its three-year life. The solution can be found at the end of the article. EXAMPLE 5 Derecognition of financial assets: Kashmir Kashmir has cash flow problems and has arranged to assign various invoices with a face value of $100,000 to a factor, in return for $85,000. All the invoices selected are from long-standing customers and are due to be collected some six months later. The factor has insisted that Kashmir guarantees to refund the face value of any invoices that have not been collected with three months of their due date. Requirement: Explain the accounting treatment of the proceeds received, and the circumstances that will lead to the derecognition of the receivables from the statement of financial position (balance sheet). The solution can be found at the end of the article. EXAMPLE 6 Split equity accounting for compound financial instruments: Yunan Yunan has raised finance by issuing a two-year, $100,000 convertible loan stock at par with a coupon rate of 2%. The effective rate of interest is 8%. Requirement: Explain and illustrate the accounting treatment of this financial instrument over its two-year life. The solution can be found at the end of the article. EXAMPLE 2 SOLUTION Available for sale: Tobago The financial asset is initially recognised when Tobago becomes a party to the purchase contract, and will be initially measured at the fair value of consideration given. This will include the transaction costs: DR Financial asset $10,500 CR Cash $10,500 On the disposal of the investment, proceeds are received in cash and the asset with its carrying value of $15,000 is derecognised. However, the gain recognised in income will not simply be the difference, as it will include the balance of the revaluation surplus previously parked in equity: DR Cash $16,000 CR Financial asset $15,000 DR Equity reserve $4,500 CR Income $5,500 EXAMPLE 3 SOLUTION Amortised cost: Ryland On the raising of the loan, the company needs to recognise a financial liability. The company is a party to a contract because it has borrowed $200,000. The liability is initially recognised at the fair value of the consideration that has been received, ie $200,000. The liability is classified and subsequently accounted for at amortised cost. This means that the income statement will reflect the effective rate of interest of 8% being charged. Because the coupon rate is only 4%, the annual cash paid is $8,000 (4% x 200,000) but the finance cost must reflect the actual effective rate of interest of 8%, ie the finance cost does not comprise just what is paid each year but also the premium on redemption as well. Accordingly, the charge to profit in the first year is $16,000. The liability will be extinguished after two years when the loan is repaid with the premium: Opening Finance Cash paid Closing balance 8% 4% on nominal value balance at year end Year 1 200,000 16,000 (8,000) 208,000 Year 2 208,000 16,640 (8,000) 216,640 (216,640) EXAMPLE 4 SOLUTION Impairment and amortised cost: Lagos On 1 January 2005, Lagos needs to recognise a financial asset. The company is a party to a contract because it has lent $10,000. The asset is initially recognised at the fair value of the consideration that has been given, ie $10,000. The asset is classified as loans and receivables, as the company originated the loan, and it will therefore be subsequently accounted using amortised cost, ie the income statement will reflect the effective rate of interest of 10% being earned. At the 31 December 2006, the current year end, the asset has a carrying value of $10,000 but is subject to an impairment review. The recoverable amount is the present value of the future expected cash flow, which is $5,000 in one year s time discounted by 10%, equalling $4,545, thus an impairment loss of $5,455 arises and has to be charged to income. Impairment review at 31 December 2006: Carrying value $10,000 Recoverable amount $4,545 (5,000 x 1/1.1) Impairment loss $5,455 At the year-end, financial assets that are classified as available-for-sale have to be remeasured at fair value, with the changes being taken to equity. With a fair value of $15,000 and a carrying value $10,500, the gain to be recognised is $4,500: DR Financial asset $4,500 CR Equity reserves $4,500

25 TECHNICAL PAGE 53 In the year to 31 December 2007, the asset will continue to be accounted for using amortised cost and so the income statement will enjoy the recognition of interest receivable of $455 (being 10% x $4,545) before being settled at $5,000 at the year end. EXAMPLE 5 SOLUTION Derecognition of a financial asset: Kashmir If we were to simply account for the legal form of the factoring then as the invoices have been assigned (ie sold), the debtors would be derecognised, and as the invoices have been sold for less than their book value, a loss arises of $15,000 that is recognised in the income statement: DR Cash $85,000 CR Asset $100,000 DR Income $15,000 However, as accountants we should be looking to account for the substance of the transaction in order to show a true and fair view. While the legal title may well have passed in this transaction, the risk associated with the debtors has not. The major risk associated with debtors is the risk of default, ie bad debt. If this happens then Kashmir has guaranteed that it will refund the factor the face value of the invoice, in other words the amount advanced plus interest. In reality, the cash received has the real potential of having to be repaid and so represents a loan. The correct accounting treatment is to keep the asset in the accounts until the risks and rewards have passed and this will only arise in six-months time when the factor collects the debts. The correct accounting treatment for the money received is: DR Cash $85,000 CR Loan $85,000 EXAMPLE 6 SOLUTION Split equity accounting for compound financial instruments: Yunan The issue of convertible loan stock is the issue of a hybrid financial instrument as it contains both debt and equity elements. It is not just a simple debt. Convertible loan stock contains an embedded derivative the option to convert the debt to shares and as such it is necessary to account separately for the debt and the equity. This is known as split equity accounting. The debt element is the obligation to repay cash and this is measured at the present value of the future cash flow. This can be ascertained as $89,301, with the equity element of $10,699 being simply the balancing figure and will be taken to reserves. The debt is then to be accounted using amortised cost so that the finance cost is based on the effective rate of interest and not just the cash paid. The finance cost in the first accounting period should be $7,144, and the year-end liability at the end of the first year should be $94,445. Working to calculate the present value of the future cash flow: Year 1 2% x 100,000 2,000 x 1/1.08 1,852 Year 2 102,000 x 1/ ,449 Debt 89,301 Equity Balancing figure 10, ,000 Working showing the amortised cost accounting on the debt element: Opening Finance Cash paid Closing balance 8% 2% on nominal value balance at year Year 1 89,301 7,144 (2,000) 94,445 Year 2 94,445 7,555 (2,000) 100,000 Tom Clendon is a financial accounting lecturer at Kaplan Financial

26 RELEVANT TO ACCA QUALIFICATION PAPERS F7 AND P2 What is a financial instrument? Part 2 My previous article covered the classification, initial measurement and subsequent measurement of financial liabilities (eg loans and bonds) and issued equity instruments (eg ordinary shares). It was established that when issuing financial instruments to raise finance, the issuer had to classify instrument as either financial liabilities (and, in turn, financial liabilities were split into amortised cost and Fair Value Through Profit or Loss (FVTPL)) or equity instruments. This can be summarised in the following diagram. Issuing financial instruments (raising finance) Financial liabilities Equity instruments Contain an obligation to repay Evidence of an ownership interest in the residual net assets If classified as amortised cost; initial measurement is at fair value less issue costs and then subsequent measurement is at amortised cost If classified as FVTPL; initial measurement is at fair value, and then so is subsequent measurement with gains and losses being recognised in the income statement Initial measurement is at fair value less issue costs and, subsequently, no change as equity instruments are not re-measured Accounting for compound financial instruments While the vast majority of financial instruments create a financial asset in one entity and a financial liability or equity instrument in the accounts of another entity, it is possible that a single financial instrument can create a financial asset in one entity and a financial liability and an equity instrument in another entity. The classic example of this arises when an entity issues a convertible bond. Accounting for the issue of convertible bonds (debt and equity in a single instrument) Convertible bonds are basically debt instruments but they also contain an option to convert into equity shares and this means that a convertible bond contains both debt and equity elements. The option to convert into equity is strictly a derivative that is embedded into the host contract. The option will be exercisable by the holder of the bond who has the option to require settlement of the debt in equity shares rather than 2012 ACCA

27 2 ACCOUNTING FOR FINANCIAL INSTRUMENTS AUGUST 2012 being repaid in cash. For accounting purposes it will be necessary on initial recognition to split out the debt and equity elements so that they can be separately accounted for. The fair value of the option is highly subjective, but the fair value of the debt element is more easily measured by discounting the future cash flows. The assumption is then made that the fair value of the option is the balancing figure. Example 1 Graham Gooch issues a 3% $200,000 two-year convertible bond at par. The effective rate of interest of the instrument is 8%. The terms of the convertible bond is that the holder of the bond, on the redemption date, has the option to convert the bond to equity shares at the rate of 10 shares with a nominal value of $1 per $100 debt rather than being repaid in cash. Transaction costs can be ignored. Graham Gooch will account for the financial liability arising using amortised cost. Required Explain the accounting for the issue of the convertible bond. Solution A convertible bond creates both an equity and a debt instrument. On initial recognition the debt element will be measured at fair value ie the present value of the future cash flow, with the equity element representing the balancing figure. Transaction costs have been ignored, but would have to split proportionately between the debt and equity elements. The value ascribed to the equity element is the balancing figure. Cash flow (3% x $200,000) Discount 8% Present value of the future cash flow Year 1 $6,000 X $5,556 Year 2 $206,000 X $176,542 Fair value of the debt element $182,098 Fair value of the equity element (balancing figure) $17,902 Proceeds of the issue $200,000 In journal entry terms the initial issue of the convertible bond can be summarised as follows: Dr Cash $200,000 Cr Financial liability $182,098 Cr Equity $17,902 The Cr to equity can be reported in a reserve entitled Other components of equity. Equity is not subsequently remeasured. The liability on the other hand will be accounted for using amortised cost charging income with a finance cost at the rate of 8% ACCA

28 3 ACCOUNTING FOR FINANCIAL INSTRUMENTS AUGUST 2012 Opening balance Income statement finance Less cash Closing balance of the liability Year 1 $182,098 $14,568 ($6,000) $190,666 Year 2 $190,666 $15,334* ($6,000) $200,000 *includes rounding At the end of Year 2 the liability can be extinguished by the payment of $200,000 in cash, or if the option is exercised by the bond holder, then it is extinguished by the issue of 20,000 $1 ordinary shares at nominal value with a share premium of $180,000 also being recorded. Financial assets Now let us turn our attention to the accounting for financial assets, as there have been some recent changes following the issue of IFRS 9, Financial Instruments which will supersede IAS 39, Financial Instruments: Recognition and Measurement. The new standard applies to all types of financial assets, except for investments in subsidiaries, associates and joint ventures and pension schemes, as these are all accounted for under various other accounting standards. IFRS 9, Financial Instruments has simplified the way that financial assets are accounted. As with financial liabilities the standard retains a mixed measurement system for financial assets, allowing some to be stated at fair value while others at amortised cost. On the same basis that when an entity issues a financial instrument it has to classify it as a financial liability or equity instrument, so 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). Financial assets have to be classified and accounted for in one of three categories: amortised cost, FVTPL or Fair Value Through Other Comprehensive Income (FVTOCI). They are initially measured at fair value plus, in the case of a financial asset not at FVTPL, transaction costs. Accounting for financial assets that are debt instruments A financial asset that is a debt instrument will be subsequently accounted for using amortised cost if it meets two simple tests. These two tests are the business model test and the cash flow test. The business model test is met where the purpose is to hold the asset to collect the contractual cash flows (rather than to sell it prior to maturity to realise its fair value changes). The cash flow test will be met when the contractual terms of the asset give rise on specified dates to cash flows that are solely receipts of either the principal or interest. These tests are designed to ensure that the fair value of the asset is irrelevant, as even if interest rates fall causing the fair value to raise then the asset will still be passively held to receive interest and capital and not be sold on. However, even if the asset meets the two tests there is still a fair value option to designate it as FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (an 'accounting mismatch') that would otherwise arise from 2012 ACCA