FINANCIAL INSTRUMENTS

CHAPTER 21
 LEARNING OUTCOMES
• To define a financial instrument and a financial asset
• Identify financial assets
• Classification of a financial asset
• Measure a financial instrument both on initial
recognition and subsequently
 FINANCIAL INSTRUMENT
• Financial instrument – Any contract that gives rise to a
financial asset of one entity and a financial liability or equity
instrument of another entity
• Result from a contract – no contract then no financial
instrument
 IDENTIFICATION

• Financial asset is any asset that is:

• Cash, or
• An equity instrument of another entity, or
• A contractual right to:
• Receive cash or another financial asset from another
entity (trade accounts receivable), or
 RECOGNITION

Financial assets are initially recognized when, and only when,

the entity becomes party to the contractual provisions of the
instrument
 CLASSIFICATION

Financial assets are classified based on two measurement

models:
• Amortised cost
• Fair value
• through profit or loss
• through other comprehensive income for debt instruments
• through other comprehensive income for equity
instruments
 CLASSIFICATION

Overview of the classification process

Each financial asset is classified by assessing:
• Its contractual cash flow characteristics (Step 1); and
• The business model within which that financial asset is
managed (Step 2)
 CLASSIFICATION

Overview of the classification process

Step 1 – CCF (contractual cash flow) test: Assessing whether
the entity will receive
• cash flows on specific dates
• that are solely payments of
• pricipal and interest

(Investment in shares fail this test)

 CLASSIFICATION

Overview of the classification process

Step 2 – BM test: Assessing the business model relevant to the
asset to determine the objectives applied in managing that
asset. Objectives may be:
• to hold the asset to sell the asset
• to collect the contractual cash flows
• to collect the contractual cash flows and to sell the asset
 CLASSIFICATION

Overview of the classification process

If a financial asset does not meet the CCF test the asset is
classified at fair value through profit or loss unless it is an
investment in an equity instrument that is not held for trading,
in which case the entity can elect to classify it at fair value
through other comprehensive income instead (can only happen
on initial recognition and is irrevocable)
 CLASSIFICATION

Overview of the classification process

If the asset does meet the CCF test the next step is to consider
the BM. If the BM is to:
• simply collect these contractual cash flows, the asset is
classified at amortised cost
• collect the contractual cash flows and also sell the asset, then
the asset is classified at fair value through other
comprehensive income
• sell the asset, then the asset is classified at fair value through
profit or loss
 CLASSIFICATION

Financial assets at amortised cost

A financial asset shall be classified as amortised cost if both
the following conditions are met:
• CCF: the contractual terms of the asset must give rise to
cash flows on specified dates and these cash flows must be
solely payments of principal and interest on the principal
amount outstanding and
• BM; the objective of the business model relevant to this
asset must be to collect contractual cash flows
 CLASSIFICATION

Financial assets at fair value through OCI

A financial asset shall be classified as fair value through OCI
if both the following conditions are met:
• CCF: the contractual terms of the financial asset must give
rise on specified dates to cash flows that are solely payments
of principal and interest on the principal amount outstanding
and
• BM; the objective of the business model relevant to this
asset must be to both collect contractual cash flows and sell
the asset
 CLASSIFICATION

Financial assets at fair value through profit or loss

A financial asset shall be classified as fair value through
profit or loss if:
• it does not meet the criteria for classification at amortised
cost and does not meet the criteria for classification as fair
value through other comprehensive income
 MEASUREMENT

Overview
The measurement of financial assets can be split into:
• initial measurement; and
• subsequent measurement
 MEASUREMENT

Overview
Initial measurement:
• Initially measured at fair value and some are adjusted for
transaction costs
• Day-one gain or loss, which arises if the fair value does not
equal the transaction price
 MEASUREMENT

Overview
Subsequent measurement:
• Depends on the financial asset’s classification
• AC
• FV
• FVPL
• FVOCI – debt
• FVOCI - equity
 MEASUREMENT

Initial measurement: FV and transaction costs (TC)

Classification Initial measurement
• FVPL FV
• FVOCI FV + TC
• Amortised cost FV + TC
 MEASUREMENT

Subsequent measurement: FA’s at amortised cost

Amortised cost FA’s are measured as follows:
• Initially at FV plus transaction costs
• Subsequently measured using the effective interest method
• Tested for impairment
• All gains or losses recognized in P/L
 MEASUREMENT

Subsequent measurement: FA’s at amortised cost

The effective interest method is defined as the method that is
used in the:
• calculation of the amortised cost of a FA, and the
• allocation and recognition of the interest revenue in P/L over
the period
The gross carrying amount is defined as:
• the amotised cost of a FA, but
• before adjusting for any loss allowance
 MEASUREMENT

Example 5: effective interest rate

• Buy debentures with a face value of R100 000 at a discount
of 3%
• The coupon rate is 12% p.a.
• Interest is payable bi-annually
• Redeemable at a premium of 7% after 5 years
Required: Calculate the effective interest rate
 MEASUREMENT

Example 5: solution
• PV = R(97 000)
• FV = R107 000
• n = 10 (5 years x 2 payments per year)
• PMT = R6 000 (R100 000 x 12% x 6/12)
Comp i = 6,934% per half year or 13,868% p.a.
 MEASUREMENT

Example 6: amortised cost

• Purchase 10% redeemable debentures for R200 000 on
1/1/20X5
• Transaction costs incurred were 1% of the cost
• Debentures redeemable at R250 000 on 31/12/20X7
• FV on 31/12/20X5 R260 000 and R280 000 on 31/12/20X6
Required: Prepare the journals for the year ended 31/12/20X5
 MEASUREMENT

Example 6: solution
• PV = R(202 000)
• FV = R250 000
• n=3
• PMT = R20 000
Comp i = 16,6386%
 MEASUREMENT

Example 6: solution
Date Payment Interest Balance
20X5 202 000
20 000 33 610 215 610
20X6 20 000 35 874 231 484
20X7 20 000 38 516 250 000
 MEASUREMENT

Example 6: solution
Date Debit Credit
01/01/20X5 Debentures at AC 202 000
Bank 202 000
31/12/20X5 Bank 20 000
Interest income 33 610
Debentures at AC 13 610
 MEASUREMENT

Subsequent measurement: FA is renegotiated

If a renegotiation does not lead to the derecognition the entity
would need to:
• calculate the revised gross carrying amount; and
• recognise a modification gain or loss in profit or loss, based
on the difference between the current carrying amount and the
revised gross carrying amount
 MEASUREMENT

Example 7: FA’s at amortised cost – with modification

• Purchase 10% redeemable debentures for R200 000 on
1/1/20X5 with transaction costs of 1% of the cost
• Debentures redeemable at R250 000 on 31/12/20X7
• FV on 31/12/20X5 R260 000 and R280 000 on 31/12/20X6
• On 3/1/20X6 renegotiated – redeemable at R300 000 on
31/12/20X8
Required: Prepare the journals for the year ended 31/12/20X6
 MEASUREMENT

Example 7: solution
• FV = R300 000
• n=3
• PMT = R20 000
• i = 16,6386
Comp PV = R233 510
 MEASUREMENT

Example 7: solution
Date Payment Interest Balance
20X5 202 000
20 000 33 610 215 610
20X6 17 900 Modification
233 510
20 000 38 853 252 363
20X7 20 000 41 990 274 352
20X8 20 000 45 648 300 000
 MEASUREMENT

Example 7: solution
Date Debit Credit
01/01/20X6 Debentures at AC 17 900
Modification gain (P/L) 17 900
31/12/20X6 Bank 20 000
Interest income 38 853
Debentures at AC 18 853
 MEASUREMENT

Subsequent measurement: FA at FV through OCI - debt

FVOCI – debt instruments are measured as follows:
• Initially at FV plus transaction costs
• Subsequently measured
• 1st step: using the EIR method; and
• 2nd step: at FV
• Tested for impairment
• Gains and losses due to:
• Changes in FV: recognised in OCI
• Anything else: recognise in P/L
 MEASUREMENT

Example 8: Debentures at FV through OCI

• Purchase 10% redeemable debentures for R200 000 on
1/1/20X5
• Transaction costs of 1% of the cost
• Debentures redeemable at R250 000 on 31/12/20X7
• FV on 31/12/20X5 R260 000 and R280 000 on 31/12/20X6
• Assume the debentures are classified at FV through OCI
Required: Prepare the journals for the year ended 31/12/20X5
and 31/12/20X6
 MEASUREMENT

Example 8: solution
• PV = R(202 000)
• FV = R250 000
• n=3
• PMT = R20 000
Comp i = 16,6386
 MEASUREMENT

Example 8: solution
Date Payment Interest Balance
20X5 202 000
20 000 33 610 215 610
20X6 20 000 35 874 231 484
20X7 20 000 38 516 250 000
 MEASUREMENT

Example 8: solution
Date Debit Credit
01/01/20X5 Deb at FVOCI 202 000
Bank 202 000
31/12/20X5 Bank 20 000
Interest income 33 610
Deb at FVOCI 13 610
31/12/20X5 Deb at FVOCI 44 390*
FV gain (OCI) 44 390
* R260 000 – R215 610 = R44 390
 MEASUREMENT

Example 8: solution
Date Debit Credit
31/12/20X6 Bank 20 000
Interest income 35 874
Deb at FVOCI 15 874
31/12/20X6 Deb at FVOCI 4 126*
FV gain (OCI) 4 126

* R280 000 – (R260 000 + (R35 874 – R20 000))

 MEASUREMENT

Subsequent measurement: FA at FV through OCI - equity

FVOCI – equity instruments are measured as follows:
• Initially at FV plus transaction costs
• Subsequently measured at FV
• Not tested for impairment
• Gains and losses: all recognised in OCI
• Dividend income: recognised in P/L
 MEASUREMENT

Example 10: Equity at FV through OCI

• Purchase 1 000 ordinary shares on 1/1/20X8 for R100 per
share
• Broker fees R8 000
• Strategic investment – present FV changes in OCI
• On 15/12/20X8 – declare a dividend of R1 per share
• 31/12/20X8 investment had a FV of R120 000
• On 5/1/20X9 – received a dividend of R1 per share
Required: Prepare the journals for the year ended 31/12/20X8
and 31/12/20X9
 MEASUREMENT

Example 10: solution

Date Debit Credit
01/01/20X8 Shares at FVOCI 100 000
Bank 100 000
01/01/20X8 Shares at FVOCI 8 000
Bank 8 000
15/12/20X8 Shares at FVOCI 1 000
Div Inc (P/L) 1 000
 MEASUREMENT

Example 10: solution

Date Debit Credit
31/12/20X8 Shares at FVOCI 11 000
FV gain (OCI) 11 000

05/01/20X9 Bank (A) 1 000

Shares at FVOCI 1 000
 MEASUREMENT

Subsequent measurement: FA at FV through P/L

FVPL – FA’s are measured as follows:
• Initially at FV (Transaction costs are expensed)
• Subsequently measured at FV
• Not tested for impairment
• Gains and losses: all recognised in P/L
• Dividend income: recognised in P/L
 MEASUREMENT

Example 11: FA’s at FV through P/L

• Purchase 25 000 shares on 1/11/20X5 for R25 000
• Transaction costs R2 500
• 30/12/20X5, a dividend of R1 000 was declared
• 31/12/20X5 investment had a FV of R55 000
• Bought shares with the intention to sell in the short term
Required: Prepare the journals to record the change in fair
value
 MEASUREMENT

Example 11: solution

Date Debit Credit
01/11/20X5 Shares at FVPL 25 000
Bank 25 000
01/11/20X5 Transaction costs (P/L) 2 500
Bank 2 500
30/12/20X5 Shares at FVPL 1 000
Div Inc (P/L) 1 000
31/12/20X5 Shares at FVPL 29 000
FV gain (P/L) 29 000