Financial instruments

International Financial Reporting Standard (IFRS®) 9 Financial Instruments is a complex standard, especially for users and preparers of financial statements. It is therefore no surprise that ACCA candidates also find it complex. Indeed, there is a well-known quote from a previous Chair of the International Accounting Standards Board (the Board) who said: ‘If you understand this [standard], you haven’t read it properly.’

IFRS 9 is relevant to the Financial Reporting (FR) syllabus, and so this article  takes a high-level review of its application to the following:

  1. Financial assets
  2. Financial liabilities
  3. Convertibles

1.  Financial assets

There are two types of financial asset (equity and debt instruments), which can be further split into different categories.

(a) Equity investments
Equity instruments are likely to be shares that have been purchased in a company, but not enough to give the investee significant influence (associate), control (subsidiary) or joint control (joint venture).

There are two options here, depending on the intention of the entity. The default category is fair value through profit or loss (FVPL).

Equity instruments: fair value through profit or loss (FVPL)
FVPL is  the default treatment for equity investments where transaction costs such as broker fees are expensed and not capitalised within the initial cost of the asset. Subsequently, the investment is revalued to fair value at each year end, with the gain or loss being taken to the statement of profit or loss.

Alternatively, equity instruments can be classified as fair value through other comprehensive income (FVOCI). It is important to note that this designation must be made on acquisition and the equity investments cannot retrospectively be treated as FVPL. This is only an option if the equity investment is intended to be a long-term investment.

Equity instruments: fair value through other comprehensive income (FVOCI)
Using FVOCI, the alternative treatment, transaction costs can be capitalised as part of the initial cost of the investment. Similar to FVPL, the instrument would then be revalued to fair value at the year end. The big difference is where the gain or loss is recorded. In FVOCI, the gain or loss is recognised within Other Comprehensive Income and held in an investment reserve. In this way it is similar to the accounting for property, plant and equipment using the revaluation model. However unlike the treatment for a revaluation surplus, there can be a negative FVOCI reserve.

When the FVOCI instrument is sold, the reserve can be left in equity, or transferred into retained earnings.

(b) Debt instruments
These are usually bonds or loan notes, or other instruments which are likely to carry interest and a capital element of repayment. The treatment of the debt instrument depends on the intention of the entity, and there are three options for categorising debt instruments.

Debt instruments: fair value through other profit or loss (FVPL)
The default category is FVPL, but this is rare within ACCA exams and it is much more common to apply one of the two alternative treatments, being amortised cost or FVOCI.

Debt instruments: amortised cost
To apply this treatment, the instrument must pass two tests; first the business model test and secondly the contractual cash flow characteristics test.

  • Business model test – the entity must intend to hold the instrument in order to collect the interest payments and receive repayment on maturity.
  • Contractual cash flow characteristics test – the contractual terms give rise to cash flows which are solely repayments of the interest and principle amount.

In the FR exam, it will only be the first test which may (or may not) be met, so management must decide on their intention for holding the debt instrument. This treatment tends to be the most common in exam scenarios, as it allows the examiner to test the principles of amortised cost accounting.

The principles of amortised cost accounting require that interest must be recorded on the amount outstanding. This is relatively straight forward for many instruments. For example, on a $10m 5% loan, with $10m repayable at the end of a three-year term, interest would simply be recorded as $500,000 a year.

The issues arise when the balance may be repaid at a premium. For example, the terms of the $10m loan, issued on 1 January 20X1, may be that the holder receives interest of 5% a year, but then receives $11m back at the end of the three year term, on 31 December 20X3. This means that the holder is now earning interest in two different ways. Firstly, they are earning the 5% payment each year. Secondly, they are earning another $1m interest over three years in the form of receiving more money back than they invested.

IFRS 9, Financial Instruments, requires that a constant rate of interest is applied to this balance to better reflect the reality of the situation. This rate takes into account both the annual payment and the premium payable on redemption. In the FR exam, this rate will be provided in the question. The question will provide information about the effective rate of interest. Let’s say that in this example, the effective rate of interest is 8.08%. This rate is applied to the outstanding balance each year in order to calculate the interest earned on the investment, which is the amount to be recorded in investment income in the statement of profit or loss.

The easiest way to do this is often to use a table showing the movement of the asset.
 

 

Balance 1 Jan
$’000
Interest 8.08%
$’000
Payment
$’000
Balance 31 Dec
$’000

20X1

10,000

808

-500

10,308

20X2

10,308

833

-500

10,641

20X3

10,641

859

-500

11,000

The figures in the interest column would be the amounts recorded as investment income in the statement of profit or loss each year. This is increasing to reflect the fact that the amount owed is increasing as it gets closer to redemption.

The balance in the final column reflects the amount owed to the entity at each year end, and shows how the balance outstanding increases from $10m to $11m over the three year period.

The double entries for the asset in year one would be as follows:

1 January 20X1 – The $10m loan is given to the third party. This reduces the entity’s cash balance, but creates a long-term receivable of $10m, meaning the entry is Dr Receivable $10m, Cr Cash $10m.

The interest then accrues over the year at the effective rate of 8.09%. This increases the amount of the receivable and is recorded in investment income, so the entry is Dr Receivable $808k, Cr Investment income $808k.

31 December 20X1 – The entity receives a payment of $500,000, being 5% of the original $10m loaned. This figure will be the same each year. This reduces the value owed to the entity, so the entry is Dr Cash $500k, Cr Receivable $500k.

The result of these entries is that the entity has a closing receivable of $10.308m. This will all be held as a non-current asset, as the amount is not receivable until 31 December 20X3.

This would carry on for the next two years, until the full amount is repaid at 31 December 20X3 with the entry Dr Cash $11m, Cr Receivable $11m.

The total interest to be recorded in the statement of profit or loss over the three years is $2.5m, being the $808k + $833k + $859k. This $2.5m represents all the interest earned by the entity over the three years. This consists of the $1.5m annual payments ($500k a year), and the additional $1m received (the difference between loaning the $10m and receiving the $11m).

Debt instruments: fair value through other comprehensive income (FVOCI)
The final possible treatment for a debt instrument is to hold it at fair value through other comprehensive income (FVOCI). Similar to holding the instrument at amortised cost, two tests must be passed in order to hold a debt instrument in this manner.

  • Business model test – the entity intends to hold the instrument in order to collect the interest payments and receive repayment on maturity, but may sell the asset if the possibility of buying one with a greater return arises.
  • Contractual cash flow characteristics test – the contractual terms give rise to cash flows which are solely repayments of the interest and principle amount.

Again, it is only the first of these that candidates will need to consider in the FR exam, highlighting that the choice of category will depend on the intention of management.

If the entity chooses to hold the debt instrument under the FVOCI or FVPL category, they will still produce the amortised cost table as above, taking the same figure to investment income. At the year end, the asset would then be revalued to fair value, with the gain or loss being recorded in either the statement of profit or loss if classed as FVPL or in other comprehensive income if classified as FVOCI.

2. Financial liabilities

In the FR exam, financial liabilities will be held at amortised cost. These will be similar to the treatment shown earlier for assets held under amortised cost. Instead of having investment income and an asset, there will be a finance cost and a liability. The major difference in the accounting treatment relates to the initial treatment upon issue of the financial liability. Initially these are recognised at NET PROCEEDS, being the cash received net of any issue costs.

Therefore if an entity looks to raise $10m of funding, but pays a broker $200,000 for raising the finance, the initial double entry is to Dr Cash $9.8m and Cr Liability with the $9.8m. Taking the $200,000 immediately to the statement of profit or loss is incorrect because this fee must be spread over the life of the instrument. This is effectively done by applying the effective interest rate to the outstanding liability, which as we stated earlier will be given to the candidates in the exam.

Here, the effective interest rate on the liability now incorporates up to three elements. It would incorporate the annual interest payable, any premium repayable on redemption, and any issue costs. This is shown in the example below.

EXAMPLE
Oviedo Co issued $10m 5% loan notes on 1 January 20X1, incurring $200,000 issue costs. These loan notes are repayable at a premium of $1m on 31 December 20X3, giving them an effective interest rate of 8.85%.

In the above example, the 5% relates to the coupon rate, which is the amount required as an annual payment each year. This is always based on the face (par) value of the instrument, so means that $500,000 will be payable annually (being 5% of $10m).

As seen in the earlier example relating to financial assets held at amortised cost, the effective interest rate will be applied to the outstanding balance in each period. Again, a table is the easiest way to calculate this, as shown below.
 

 

Balance 1 January
$’000
Interest 8.85%
$’000
Payment
$’000
Balance 31 December
$’000

20X1

9,800

867

-500

10,167

20X2

10,167

900

-500

10,567

20X3

10,567

933

-500

11,000

The entries in 20X1 will be as follows:

1 January 20X1 – The loan is issued, meaning that Oviedo Co receives $9.8m, being the $10m less the issue costs. Therefore the entries are Dr Cash $9.8m, Cr Liability $9.8m.

Over the year, interest on the liability is accrued at the effective interest rate of 8.85%, giving the entry Dr Finance cost $867k, Cr Liability $867k.

31 December 20X1 – The payment of $500k is made, giving the entry Dr Liability $500k, Cr Cash $500k.

This leaves a closing liability of $10.167m. This will all be sat as a non-current liability, as none of it will be repayable until 31 December 20X3.

If we look at the interest column, we will see that the total interest paid is $2.7m ($867k + $900k + $933k). This is the total which will be expensed to the statement of profit or loss over the three year period. This amount consists of three elements:

  • $1.5m in annual payments ($500k a year)
  • $1m premium repaid (issued $10m loan, but repaid $11m)
  • $200k issue costs

As we can see, the issue costs have been expensed over three years, rather than being expensed immediately in 20X1.

3. Convertibles

Convertible instruments are instruments which give the holder the right to either demand repayment of the principle amount or to write off the debt and instead convert the balance into shares. In the FR exam, you will only have to deal with convertible instruments from the perspective of the issuer, being the person who has received the cash.

Convertible instruments present a special challenge, as these could ultimately result in the issue of shares or the repayment of the loan, but the choice will be in the hand of the holder. As we do not know whether the holder will choose to receive the cash or convert the instrument into shares, we must reflect an element of both within the financial statements. Therefore these are accounted for initially using split accounting, splitting it into the equity and liability components.

The liability component is the first thing to calculate. We work this out by calculating the present value of the payments at the market rate of interest (using the interest on an equivalent bond without the conversion option). The discount rates required to do this will be given to you in the exam.

In reality the market rate of interest will be higher than the coupon rate, being the annual amount payable to the holder of the loan. This is because the holder of the loan is willing to accept a lower rate of annual interest compared to the market, in exchange for the option to convert the loan into shares.

Once the liability component has been calculated, the equity component is then worked out. This is simply a balancing figure, and represents the difference between the cash received and the liability component.

EXAMPLE
Oviedo Co issued $10m 5% convertible loan notes on 1 January 20X1. These will either be repaid at par on 31 December 20X3, or converted into shares on that date. Equivalent loan notes without the conversion carry an interest rate of 8%. Relevant discount rates are shown below.
 

Amount payable in:

Discount factor at 5%

Discount factor at 8%

1 year

0.952

0.926

2 years

0.907

0.857

3 years

0.864

0.794

it is important to note that the 5% discount rates are a red herring . It is the discount rates for the market rate of interest that are important, i.e. 8%. The only thing we need the 5% for is to work out the annual payment. As these are $10m 5% loan notes, this simply means that Oviedo Co will need to make an annual payment of $500k in relation to these.

Therefore we can work out the value that the market would place on these loan notes by looking at the present value of all the payments, discounted at the market rate of interest. If this is a normal loan, ignoring the conversion, Oviedo Co would pay $500k in years 20X1 to 20X3, and then make a final repayment of $10m on 31 December 20X3.

As the market rate of interest is 8%, the present value of these payments can be calculated. These are calculated in the table below.
 

Year

Payment
$’000

Discount factor 8%

Present value
$’000

20X1

500

0.926

463

20X2

500

0.857

428.5

20X3

10,500

0.794

8,337

Total

 

 

9,229

The present value of all of the payments can be seen as $9.229m. This means that Oviedo Co received $10m, but the present value of the payments to be made have an initial value of only $9.229m. As a result, the holders of the loan notes are effectively losing $771k compared to if they had simply given Oviedo Co a normal loan at the market rate of interest.

This $771k is the amount of interest the holders are willing to lose in order to have the option to convert the loan into shares. This is taken as the initial value of the equity element.

On 1 January 20X1, the double entry to record the transaction in the records of Oviedo Co are as follows:

Dr Cash $10m – reflecting the full cash received from the issue of the convertibles.

  • Cr Liability $9.229m – reflecting the present value of the liability on 1 January 20X1
  • Cr Equity $0.771m – reflecting the value of the equity component.

The equity balance would be held as ‘convertible options’ within other components of equity. Subsequently, this equity amount remains fixed until conversion, but the liability must be held at amortised cost. This must be built back up to $10m over the next 3 years, to reflect the amount which the holder would require if they demand repayment rather than conversion of the loan notes.
 

 

Balance 1 January
$’000
Interest 8.85%
$’000
Payment
$’000
Balance 31 December
$’000

20X1

9,229

738

-500

9,467

20X2

9,467

757

-500

9,724

20X3

9,724

776

-500

10,000

As with the financial liability noted earlier, the interest column is taken to the statement of profit or loss each year as a finance cost.

At the end of the three years, Oviedo Co will either repay the $10m liability, or this will be turned into shares, with the $10m balance and the option balance of $771k transferred to share capital and share premium.

Summary

This article has considered the key issues relating to financial instruments. To perform well at FR, it is essential that candidates are able to identify the potential treatments for financial assets, produce amortised cost calculations and understand the accounting entries required for a convertible instrument. This is one of the most technical areas of the syllabus, but also one of the central areas which will be further developed in Strategic Business Reporting.

Written by a member of the Financial Reporting examining team