ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 11: Financial instruments

 The combined contract is not measured at fair value, with changes in fair value

recognised as profit or loss. If the combined contract is already accounted for at

fair value (as for a derivative), there is no need to separate the two elements.

 The economic characteristics and risk features of the embedded derivative are

not closely related to those of the host contract.

When these conditions are met, the embedded derivative is separated from the host

contract and accounted for like any other derivative. The host contract is accounted

for in accordance with the relevant accounting standard, separately from the

derivative.



Example

A company invests in a convertible debt instrument costing $25,000. The fixed

interest rate is 7%. At the end of ten years, the instrument can be converted into

ordinary shares, at the option of the company. Otherwise, the capital of $25,000 will

be repaid. The investment is classed as available-for-sale. The fair value of the

equity option has been estimated as $3,250.

The embedded derivative is the option to convert the debt instrument into equity at

the end of ten years. The host contract is the debt instrument. The embedded

derivative must be separated from the host contract because the conditions listed

above are met:

 There is an embedded derivative.

 The debt instrument is not measured at fair value, with changes in fair value

recognised as profit or loss.

 The debt and equity do not have closely-related characteristics.

Since the fair value of the embedded derivative (the equity option) is $3,250, the

transaction is recognised as follows:

Debit Credit

$ $

Available‐for‐saleinvestment 21,750

Derivativeasset 3,250

Cash

25,000

Subsequently, the available-for-sale investment and the derivative will be accounted

for in different ways. (Accounting for financial instruments is explained later. It may

be helpful to note that the derivative will be treated as a financial asset held at fair

value, and the debt instrument will be accounted for as an ‘available for sale’

investment.)

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1.5 IFRIC 9: Reassessment of embedded derivatives

IFRIC Interpretation 9 clarifies the treatment of embedded derivatives. IAS 39

requires an entity to determine whether the derivative needs to be separated from

the host contract when first becoming party to the contract. IFRIC 9 details whether

this should be reassessed during the life of the contract.

The consensus is that the embedded derivative is assessed when the entity first

becomes party to the contract and reassessment is prohibited unless there is a

significant change in the contract.

1.6 The accounting standards for financial instruments

It is important that users of financial statements should be aware of the nature of the

financial instruments of an entity. In the case of derivatives, there is little or no cost

involved in establishing a position in derivatives, but they can expose the company

to very substantial financial risks. For example, normal forward contracts do not

cost anything to arrange. It would be inappropriate to ignore the derivatives in the

financial statements on the grounds that their original cost was nil or very small.

Chapter 11: Financial instruments

IAS 39: Recognition and measurement

 Recognition of financial instruments

 Initial measurement

 Classes of financial asset

 Classes of financial liability

 Subsequent measurement

 Subsequent measurement at fair value

 Subsequent measurement at amortised cost

 Trade receivables

 Impairment of financial instruments

 Derecognition

2 IAS 39: Recognition and measurement

2.1 Recognition of financial instruments

A financial asset or a financial liability should be recognised in the statement of

financial position when the reporting entity becomes a party to the contractual

provisions of the instrument.

This is different from the normal recognition criteria for an asset or a liability. The

IASB’s Framework states that an item should be recognised when there is a

probable inflow or outflow of economic benefits.

The effect of this is that all financial assets and liabilities, including derivatives, are

recognised in the statement of financial position, even if they have no cost.

For example, an entity takes out a forward contract to buy a specified amount of

foreign currency at a fixed price on a future date. (This contract is a derivative.) The

entity recognises the contract on the commitment date, instead of waiting until the

foreign currency is actually purchased at the future date in the contract.

IAS 39 defines four classes of financial asset and two classes of financial liability and

every financial instrument must be allocated to one of these classes on initial

recognition.

2.2 Initial measurement

A financial instrument should initially be measured at cost. This is the fair value of

the consideration given or received.

In the case of a forward arrangement, this will often be a zero cost, because nothing

is paid to acquire the financial derivative, and there is no obvious gain or loss to

either party from the transaction at the time that it is made.

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It may seem odd that a financial instrument needs a recognised cost when it is $nil,

but it is important to recognise these items in the accounting system, because their

measurement will be re-assessed at the end of the next reporting period.

When a financial instrument is acquired, there will usually be transaction costs

incurred in addition to any purchase cost. For example, transaction costs may

include a broker’s fees. The accounting treatment of these fees depends on the class

of financial instrument.

Class of financial asset Treatment

Fair value through profit or loss The transaction cost is expensed and written

off in full as an expense in profit and loss.

All other classes The transaction cost is capitalised and

included in the initial cost of the financial

instrument.

2.3 Classes of financial asset

After initial recognition, financial assets are classified into four categories. The way

in which they are measured depends on the category in which they are placed.

(1) Financial assets at fair value through profit or loss. These are financial assets

held for onward sale in the short term, speculative derivatives, and any other

financial assets that the entity chooses to include in this category.

A financial instrument is held for trading if it is:

 acquired principally for the purpose of selling or repurchasing it in the

near future; and

 part of a portfolio of instruments that are managed together.

An entity can choose to treat other financial instruments as ‘at fair value

through profit or loss’, provided that they meet certain criteria.

Equity instruments that do not have a quoted price in an active market cannot

be included in this category.

(2) Held to maturity investments. These are financial assets with fixed payments

and a fixed maturity that the entity seriously intends to hold until their

maturity. An example is an investment in bonds issued by another entity,

where there is no intention to sell the bonds on the market before their

maturity.

Loan stock, redeemable preference shares and bonds issued by other entities

would fall into this category, provided that the entity plans to hold the

investment to the end of its term (for example, when it is redeemable). The

entity must also expect to have sufficient cash or other resources available, so

that it will not be forced to sell the investment before the end of its term.

(3) Loans and receivables. These are assets with fixed payments but are not

quoted in an active market. They include regular bank loans and accounts

Chapter 11: Financial instruments

receivable (trade receivables). They are not expected to be sold in the near

future.

This category could include loans made to other entities, trade receivables and

investments in bonds and other forms of debt, provided that the other

conditions are met.

(4) Available-for-sale financial assets. These are any other financial assets that

do not fall into any of the three categories above. In addition, an entity can

designate an asset as available-for-sale when it is first recognised.

2.4 Classes of financial liability

There are two categories of financial liabilities:

(1) Financial liabilities at fair value through profit or loss. These are financial

liabilities, but with a definition similar to the corresponding category of

financial assets – for example, speculative derivatives that create a liability.

(2) Financial liabilities measured at amortised cost. This category is for all

remaining financial liabilities.

These categories of financial assets and liabilities do not affect the initial recognition

of the financial instrument in the financial statements. However, they do affect the

method of accounting for the financial instrument after initial recognition.

2.4 Subsequent measurement

Although financial instruments are initially recorded at cost, IAS 39 requires that the

value of financial instruments should be re-assessed at each reporting date (the end

of the reporting period or the settlement date for the financial instrument).

The method of re-assessing their value depends on the category of financial

instrument.

When the carrying value of a financial instrument is re-assessed at fair value, there

will be a difference between its previous carrying value and its new carrying value

(new fair value). This difference is a gain or loss, which must be accounted for.

The method of accounting for the gain or loss on re-assessment of the carrying value

also depends on the class to which the financial instrument belongs.

Class of instrument Fair value Amortised cost

Financial assets

Assets at fair value

through profit or loss

Re-value at fair value.

Gain or loss to be taken

to proft and loss (the

income statement).

Held to maturity Value at amortised cost

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Class of instrument Fair value Amortised cost

Loans and receivables Value at amortised cost

Available-for-sale

Re-value at fair value.

Gain or loss to be

reported as other

comprehensive income

and taken directly to an

equity reserve.

Financial liabilities

Liabilities at fair value

through profit or loss

Re-value at fair value.

Gain or loss to be taken

to profit and loss (the

income statement).

Liabilities measured at

amortised cost

Value at amortised cost

Valuation at amortised cost is explained later.

2.5 Subsequent measurement at fair value

When the value of a financial instrument is re-assessed at fair value, IAS 39

establishes a hierarchy to be used when deciding what is the fair value. The fair

value of a financial instrument should be:

(1) Published price quoted in an active market

(2) If there is no active market:

− the price of the most recent transaction in a market

− otherwise a price obtained using a valuation technique, such as the Black

Scholes pricing model for options pricing.

A fair value model re-assessment is used for two categories of financial assets:

 financial assets at fair value through profit or loss, and

 available-for-sale financial assets.

However, the resulting gain or loss on marking the investments to their market

value is dealt with differently in each case:

 Fair value through profit or loss – The gain or loss is taken to profit and loss

(the income statement) for the period.

 Available-for-sale – The gain or loss is reported as other comprehensive income

in the statement of comprehensive income and taken to a separate reserve in

equity. This reserve is then ‘recycled’ when the investment is sold. Recycling

means that the cumulative gains or losses relating to this investment are

removed from the reserve and taken to profit or loss as part of the gain or loss

when the asset is eventually disposed of. Since the gain or loss has previously

been reported in other comprehensive income, a reclassification adjustment is

Chapter 11: Financial instruments

required, in accordance with IAS1. The gain (or loss) recognised in profit or loss

is offset by a matching loss (or gain) in other comprehensive income, to avoid

double counting.



Example

 An investment is purchased for $30,000 plus 1% transaction costs on 1 April

20X6. It is classified as available for sale. At the end of the financial year, which is

31 March 20X7, the investment is re-valued to its fair value. This is $40,000. On

11 December 20X7 it is sold for $50,000.

 Initially, the investment will be recorded at cost at $30,300. This is the cost plus the

capitalised transaction costs. At the end of the financial year (31 March 20X7) the

investment is re-valued to its fair valued of $40,000. There is a gain of $9,700 ($40,000

– $30,300). This gain of $9,700 is included as other comprehensive income in the

statement of comprehensive income for the year to 31 March 20X7, and is taken

directly to an ‘Available for sale reserve’ in equity.

The company will need to keep a record of what each financial instrument

contributes to this reserve, so that when it is eventually sold, the appropriate

amount can be recycled.

The journal entry to record the disposal for the above example is as follows:

$ $

DRCash 50,000

CRInvestment

40,000

DRAvailableforsalereserve 9,700

CRProfitorloss

19,700

The profit of $19,700 represents the gain on disposal of $10,000 ($50,000 – $40,000)

plus the recycled profit from the available sale reserve of $9,700.

The $9,700 gain is reclassified from other comprehensive income in the previous

year, and in the year to 31 March 20X8, profit or loss will include the realised gain of

$9,700 (as shown above), but there should also be an offsetting reduction of $9,700 in

other comprehensive income for the year, to prevent double-counting of the $9,700

in income.

2.6 Subsequent measurement at amortised cost

Some categories of financial asset (held to maturity investments and loans and

receivables) are measured at amortised cost after their initial recognition. Amortised

cost is calculated as follows for a financial asset:

 Amount initially recognised (initial cost of investment), plus

 Interest income recognised (using the effective rate), minus

 Amounts of interest actually received.

The effective rate is the internal rate of return implicit in the financial instrument.

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Similarly, the amortised cost of a financial liability is calculated as:

 Amount initially recognised as a liability (initial cost), plus

 Interest expense recognised (using the effective rate), minus

 Amounts of interest actually paid.

The following example illustrates these terms and calculations.



Example

A bond with an issue value of $1 million will pay a coupon rate of 5% interest for

two years, then 7% interest for two years. Interest is paid annually on the

anniversary of the bond issue. The bond will be redeemed at par after four years.

The company that issued the bond uses the amortised cost method for its valuation.

 What is the effective rate?

 What is the amortised cost at the end of each year?



Answer

This financial instrument is called a ‘stepped bond’, because the interest payment

increases (goes up a step) over the life of the bond. The effective rate is the rate that

matches the amount raised from the bond issue (or, in the case of an investment in a

bond, its original cost) with the discounted future cash flows from the bond. It is the

discount rate that, when applied to the future interest and redemption cash flows,

will give a net present value of zero. (It is the internal rate of return on the bond.)

In this example, the effective interest rate is 5.942%. (Workings are not shown.)

The amortised cost model uses this effective rate to determine the interest to be

charged in profit and loss in each period. The interest charged in profit and loss

(the income statement) each year is not the cash paid. The interest charged is

calculated by applying the effective rate to the outstanding balance on the bond at

the beginning of the period.

The outstanding balance at the end of a period is the opening balance plus the

interest charge at the effective rate, minus the actual interest payments in the period.



Year

Bondvalue

broughtforward

Interestat

5.942%

Cashpaid

Bondvalue

carriedforward

1 1,000,000

59,424

(50,000) 1,009,424

2 1,009,424

59,983

(50,000) 1,019,407

3 1,019,407

60,577

(70,000) 1,009,984

4 1,009,984

60,016

(70,000) 1,000,000

240,000

Chapter 11: Financial instruments

The bond value is initially recorded at cost ($1 million) and by the end of year 1 it

has an amortised cost of $1,009,424.

The total interest paid over the four years is $240,000. However, it is charged to the

income statement each year at the effective rate (5.942%) on the outstanding balance,

not as the actual interest paid on the bonds in cash each year.

This treatment of the interest costs prevents companies from issuing instruments

with step payments to manipulate their income statements from one year to

another.

If this bond was classified by its holder as a held-to-maturity investment, the

calculations would be the same. However, the interest calculated for each period

would be income in profit or loss, since the bond is a financial asset. This should be

deducted from the value of the asset and the amount of cash actually received

should be added. At the redemption date for the bonds investment, its amortised

cost/value will be the amount receivable from the company when the bonds are

redeemed.



Example

X purchased a loan on 1 January 20X5 and classified it as ‘held to maturity’. The

financial year of X ends on 31 December.

Terms:

Nominalvalue $50million

Couponrate 10%

Termtomaturity 3years

Purchaseprice $48million

Effectiverate 11.67%

Required

(a) Calculate the income for X each year.

(b) Show how this income will be allocated over the three years and calculate the

amortised cost that will appear in the statement of financial position in

years 1 - 3.



Answer

(a) The total income from the loan consists of:

 annual interest at the coupon rate, plus

 $2 million premium on the redemption of the loan

This equates to an effective rate of 11.67% (the IRR). This constant rate will be

applied to the outstanding balance each year in order to calculate the interest

income to be recognised in profit and loss.

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(b) The amount recognised as income in profit or loss each year is based on the

effective rate of return, but the cash actually paid is based on the coupon rate

of 10%. The difference is treated as an adjustment to the carrying value of the

investment in the statement of financial position, which is the amortised cost

of the asset. This is calculated as follows:

Year

Assetvalue

broughtforward

Interestat

11.67%

Cashpaid

Assetvalue

carriedforward

20X5

48.00m 5.60m

(5m) 48.06m

20X6 48.60m 5.65m

(5m) 49.25m

20X7

49.25m 5.75m

(5m) 50.00m

17m

15m

2.7 Trade receivables

Trade receivables belong to the category ‘loans and receivables’ under IAS 39.

Initially, they are valued at fair value, which is the invoiced amount. Because they

are short-term receivables, they are not discounted to present value, and do not

have an effective interest rate.

However they have to be assessed for impairment at the end of each reporting

period, and will be impaired if the value of the expected cash flows is less than the

carrying amount. The assessment for trade receivables may be on an individual or a

group basis.

The traditional methods of calculating ‘bad debt provisions’ (such as a percentage of

receivables more than 60 days overdue) are unlikely to produce a correct figure for

the present value of the future cash flows, and making ‘general provisions’ does not

comply with the methodology set out in IAS 39.

IAS 39 states that the carrying amount of the asset should be reduced, either directly

or through the use of an ‘allowance account’. The amount of the loss should be

included in the income statement.

This means that an allowance for impairment losses on trade receivables (doubtful

debts) remains possible. However, this impairment loss must be determined in a

more logical and systematic way than has often been used in the past.

2.8 Impairment of financial instruments

Impairment of most non-current assets is covered by IAS 36, but impairment of

financial instruments is dealt with by IAS 39. An entity must assess for evidence of

impairment at the end of each reporting period.

A financial asset is impaired if its carrying amount exceeds it estimated recoverable

amount. For financial assets carried at amortised cost, estimated recoverable amount

is the present value of estimated future cash flows from the asset.

Indicators of impairment might include:

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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