* 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.
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 measuring assets or liabilities or recognising the gains and losses on them on different bases. An example of where it is appropriate to use the fair value option and, thus, avoid an accounting mismatch is where an entity holds a financial asset that is debt and that carries a fixed rate of interest, but is then hedged with an interest rate swap that swaps the fixed rates for floating rates. The interest swap is a financial instrument that would be held at FVTPL and so, accordingly, the financial asset classified as debt also needs to be at FVTPL to ensure that the gains and losses arising from both instruments are naturally paired in income and, thus, reflect the substance of the hedge. If the financial asset classified as debt was accounted for at amortised cost, then this would create the accounting mismatch.
All other financial assets that are debt instruments must be measured at FVTPL.
Accounting for financial assets that are equity instruments (for example, investments in equity shares)
Equity investments have to be measured at fair value in the statement of financial position. As with financial assets that are debt instruments, the default position for equity investments is that the gains and losses arising are recognised in income (FVTPL). However, there is an election that equity investments can at inception be irrevocably classified and accounted as FVTOCI, so that gains and losses arising are recognised in other comprehensive income, thus creating an equity reserve, while dividend income is still recognised in income. Such an election cannot be made if the equity investment is acquired for trading. On disposal of an equity investment accounted for as FVTOCI, the gain or loss to be recognised in income is the difference between the sale proceeds and the carrying value. Gains or losses previously recognised in other comprehensive income cannot be recycled to income as part of the gain on disposal.
For example, let us consider the case of an equity investment accounted for at FVTOCI that was acquired several years ago for $10,000 and by the last reporting date has been revalued to $30,000. If the asset is then sold for $31,000, the gain on disposal to be recognised in the income statement is only $1,000 as the previous gain of $20,000 has already been recognised and reported in the other comprehensive income statement. IFRS 9 requires that gains can only be recognised once. The balance of $20,000 in the equity reserves that relates to the equity investment can be transferred into retained earnings as a movement within reserves.
The accounting for financial assets can be summarised in the diagram below.
Reclassification of financial assets
As we have seen once an equity investment has been classified as FVTOCI this is irrevocable so it cannot then be reclassified. Nor can a financial asset be reclassified where the fair value option has been exercised. However if, and only if the entity's business model objective for its financial assets changes so its previous model assessment would no longer apply then other financial assets can be reclassified between FVTPL and amortised cost, or vice versa. Any reclassification is done prospectively from the reclassification date without restating any previously recognised gains, losses, or interest.