Financial Instruments: IFRS 7, 9 & IAS 32

Overview

This unit covers the recognition, measurement, presentation, and disclosure of financial instruments in accordance with International Financial Reporting Standards (IFRS), focusing on IFRS 7, IFRS 9, and IAS 32. It is essential for understanding how companies account for and report financial assets, liabilities, and equity instruments.

Reporting Framework

IFRS vs IFRS for Small and Medium Enterprises (SMEs)

• IFRS 7, 9, and IAS 32 apply to all financial instruments except specific exclusions (e.g., interests in subsidiaries, leases, employee benefits, insurance contracts).

• IFRS for SMEs (Sections 11 & 12) prescribes similar but simplified requirements for SMEs, with some differences in scope and classification.

Table: Main Differences between IFRS and IFRS for SMEs

Background and Current Accounting Position

• Financial instruments are widely used by businesses for operations, financing, investment, and risk management.

• Major standards: IFRS 9 (classification, measurement, impairment), IAS 32 (presentation), IFRS 7 (disclosure).

• Objective: Provide relevant information for users to assess amounts, timing, and uncertainty of future cash flows.

Definitions

Key Terminology

• Financial Instrument: A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

• Financial Asset: Cash, equity instrument of another entity, or a contractual right to receive cash or another financial asset.

• Financial Liability: Contractual obligation to deliver cash or another financial asset, or to exchange financial instruments under potentially unfavorable conditions.

• Equity Instrument: Contract evidencing a residual interest in the assets of an entity after deducting all liabilities.

Examples:

• Buying shares: Buyer records a financial asset; issuer records equity.

• Borrowing funds: Borrower records a financial liability; lender records a financial asset.

Types of Financial Instruments

• Bonds/Debentures: Debt certificates with fixed interest, often issued by governments.

• Loans: Borrowed funds with repayment of principal and interest.

• Ordinary Shares: Equity instruments with voting rights and residual claim on assets.

• Preference Shares: Shares with preferential rights to dividends and liquidation proceeds.

Related Terms

• Dividends: Profit distributions to shareholders.

• Interest: Compensation for the use of borrowed funds.

• Principal: The face value of a financial instrument.

• Offsetting: Netting a financial asset and liability if there is a legal right and intent to settle net.

Recognition

Initial Recognition

• Recognize a financial asset or liability when the entity becomes a party to the contractual provisions.

• Unconditional receivables/payables: Recognized when contract is entered.

• Planned future transactions: Not recognized until a contract exists.

Measurement of Financial Instruments

Definitions

• Fair Value: Price at which an asset or liability could be exchanged in an orderly transaction between market participants.

• Transaction Costs: Incremental costs directly attributable to acquisition, issue, or disposal of a financial instrument.

Classification of Financial Assets and Liabilities

• Classification depends on the business model and contractual cash flow characteristics.

• Categories for assets: Fair value through profit or loss (FVTPL), Fair value through other comprehensive income (FVOCI).

• Categories for liabilities: Fair value through profit or loss (amortised cost not covered in this module).

Financial Assets at Fair Value Through Profit or Loss (FVTPL)

• Default category for assets not meeting other criteria.

• Includes assets held for trading or designated as FVTPL at initial recognition.

• Example: Shares bought for speculation are classified as FVTPL.

Financial Assets at Fair Value Through Other Comprehensive Income (FVOCI)

• For equity instruments not held for trading and certain debt instruments.

• Example: Long-term investment in shares, or bonds held to collect cash flows and for sale.

Initial Measurement

Subsequent Measurement

Examples

• Buying shares for trading: Initial recognition at fair value (exclude transaction costs), subsequent changes in profit or loss.

• Buying shares for long-term investment: Initial recognition at fair value plus transaction costs, subsequent changes in OCI.

Financial Liabilities at Fair Value Through Profit or Loss

• Measured at fair value, excluding transaction costs.

• Subsequent changes in fair value recognized in profit or loss (except for changes in credit risk, which may go to OCI).

Impairment of Financial Assets

• IFRS 9 requires recognition of expected credit losses for certain financial assets.

• Credit loss: Difference between contractual cash flows and expected cash flows, discounted at the effective interest rate.

Derecognition

Derecognition of Financial Assets

• Remove asset when contractual rights expire or asset is transferred and transfer qualifies for derecognition.

• Assets must be remeasured to fair value before derecognition.

Derecognition of Financial Liabilities

• Remove liability when it is extinguished (settled, cancelled, or expired).

• Example: Settling a loan with an investment asset.

Presentation

Liabilities and Equity

• Classification depends on the substance of the contractual arrangement.

• Key distinction: Existence of a contractual obligation to deliver cash or another financial asset.

• Preference shares may be classified as liabilities or equity depending on redemption terms.

Classification of Preference Shares

• Redeemable at holder's option: Financial liability.

• Redeemable at issuer's option or convertible to equity: Equity instrument.

Interest, Dividends, Losses, and Gains

• Classification in financial statements depends on whether the instrument is a liability or equity.

• Interest on liabilities: Profit or loss.

• Dividends on equity: Directly in equity.

Transaction Costs on Equity Instruments

• Deducted from equity if directly attributable to equity transactions.

Disclosure

• IFRS 7 requires disclosure of categories, carrying amounts, and gains/losses for financial instruments.

• Fair value adjustments for FVTPL: Profit or loss.

• Fair value adjustments for FVOCI: Other comprehensive income and mark-to-market reserve in equity.

Summary Table: Financial Asset Categories

Key Formulas

• Fair Value Adjustment:

• Effective Interest Rate (using financial calculator):

• Credit Loss:

Examples of Disclosure

• FVTPL: Recognize fair value adjustment in profit or loss; disclose under current assets.

• FVOCI: Recognize fair value adjustment in OCI; disclose under non-current assets and mark-to-market reserve in equity.