Module 5 – Financial Instruments
Lesson 1: Presentation of Financial Instruments
PAS 32, paragraph 11, defines a financial instrument is “any contract that gives rise to a
financial asset of one entity and a financial liability or equity instrument of another entity.” Thus,
the term financial instrument encompasses a financial asset, a financial liability and an equity
instrument.
Characteristics of Financial Instruments
1. There must be a contract
2. There are at least two parties to the contract
3. The contract shall give rise to a financial asset of one party and financial liability or equity
instrument of another party
Examples of Financial Instrument
Cash in the form of notes and coins
Cash in the form of checks
Cash in bank
Trade accounts
Note and loan
Debt security
Equity security
Financial Assets
A financial asset is any asset that is:
Cash
An equity instrument of another entity
A contractual right to receive cash or another financial asset from another entity (ex. A/R)
A contractual right to exchange financial instrument with another entity under conditions
that are potentially favourable (ex. Stock’s rights)
A contract that will or may be settled in the entity’s own equity instruments and is not
classified as the entity’s own equity instruments.
Examples of Financial Assets
Cash and cash equivalents (e.g., cash on hand, in banks, short-term money placements,
and cash funds)
Receivables such as accounts, notes, loans, and finance lease receivables
Investments in equity or debt instruments of other entities such as held for trading
securities, investments in subsidiaries, associates, joint ventures, investments in bonds, and
derivative assets
Sinking fund and other long-term funds composed of cash and other financial assets
Nonfinancial Assets
Physical assets, such as inventory, property, plant and equipment
Intangible assets, such as patent and trademark
Prepaid expenses for which future economic benefit is the receipt of goods or services,
rather than the right to receive cash or another financial asset (ex. Prepaid rent and prepaid
insurance)
Right of use asset or leased asset is not a financial asset because control of the underlying
asset does not give rise to a present right to receive cash or another financial asset.
The entity’s own equity instrument (e.g., treasury shares)
Financial Liability
A financial liability is any liability that is a contractual obligation:
To deliver cash or other financial asset to another entity
To exchange financial assets or liabilities with another entity under conditions that are
potentially unfavorable to the entity
A contract that will or may be settled in the entity’s own equity instruments and is not
classified as the entity’s own equity instrument
Examples of Financial Liabilities
Payables such as accounts, notes, loans and bonds payable
Lease liabilities (payable in cash)
Held for trading liabilities and derivative liabilities
Redeemable preference shares issues (substance over form – they have maturity like
liabilities)
Security deposits and other returnable deposits
Nonfinancial Liabilities
Deferred revenue and warranty obligations are not financial liabilities because the
outflow of economic benefits is the delivery of goods and services rather than a contractual
obligation to pay cash.
Income tax payable is not a financial liability because it is imposed by law and
noncontractual. (ex. Taxes, SSS, Philhealth, and Pag-IBIG payables – not based on contract
but law)
Constructive obligations are not financial liabilities because the obligation do not arise
from contract (not based on contract but goodwill)
Equity Instrument
Equity instrument is any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities. (ex. Shares of stocks)
PRESENTATION OF FINANCIAL INSTRUMENTS
When to be considered as liability and when to be considered as equity
PAS 32, paragraph 15, provides that the issuer of a financial instrument shall classify the
instrument as a financial liability or equity instrument in accordance with the substance of the
contractual arrangement and the definition of a financial liability, financial asset and equity
instrument.
Paragraph 16 further provides that to determine whether a financial instrument is an
equity instrument rather than a financial liability, the instrument is an equity instrument if the
instrument includes no contractual obligation to deliver cash or another financial asset.
Redeemable Preference Share
A preference share that provides for mandatory redemption by the issuer for a fixed or
determinable amount at a future date is a financial liability of the issuer because the issuer
has a contractual obligation to pay cash at some future time.
A preference share that gives the holder the right to require the issuer to redeem the
instrument at a particular date for a fixed or determinable amount is also a financial liability
because the issuer has a contractual obligation to pay cash at some future time.
Accordingly, dividends paid to holders of mandatory redeemable preference shares shall be
accounted for as interest expense. The mandatorily redeemable preference shares shall be
classified as current or noncurrent liability depending on the date of redemption.
Compound Financial Instruments
A compound financial instrument is a financial instrument that, from the issuer’s
perspective, contains both a liability and an equity component. These components are classified
and accounted for separately, as follows:
The value assigned to the liability component is its fair value without the equity feature.
The value assigned to the equity component is the residual amount after deducting the
value assigned to the liability component from the total fair value of the compound
instrument.
Ex. Convertible Bond Shares (110 = 100 – FL and 10 – EI) Preference Share (100)
Cash 110
Bonds payable 100
Share premium 10
Interest, Dividends, Losses and Gains
Offsetting of Financial Assets and Financial Liabilities
A financial asset and a financial liability are offset and only the net amount is presented in
the statement of financial position when the entity has both:
a legal right of setoff and
an intention to settle the amounts on a net basis or simultaneously
ex. A (10,000 – payable and 1,5000 - receivable) and B (15,000 - payable) – A cannot offset payment
unless ^^
Lesson 2: Recognition and Measurement of Financial Instruments
Initial Recognition
An entity shall recognize a financial asset or a financial liability in its statement of financial
position when and only when the entity becomes a party to the contractual provisions of the
instrument. (PFRS 9.par3.1.1)
PFRS9, paragraph 5.1.1, provides that at initial recognition, an entity shall measure a
financial asset at fair value plus, in the case of financial asset not at fair value through profit or loss,
transaction costs that are directly attributable to the acquisition of the financial asset.
As a rule, transaction costs that are directly attributable to the acquisition of the financial
asset shall be capitalized as cost of the financial asset.
However, if the financial asset is held for trading or if the financial asset is measured at fair
value through profit or loss, transaction costs are expensed outright.
Subsequent Measurement
PFRS 9, paragraph 5.2.1, provides that after initial recognition, an entity shall measure a
financial asset at:
1. Fair vale through profit or loss (FVPL)
2. Fair value through other comprehensive income (FVOCI)
3. Amortized cost
The measurement depends on the business model (for managing the financial assets) of
managing financial asset which may be to realize fair value changes and to collect contractual cash
flows (characteristics of the financial assets).
Financial Assets at Fair Value Through Profit or Loss
The following financial assets shall be measured at fair value through profit or loss:
1. Financial assets held for trading
2. All other investments in quoted equity instruments
3. Debt investments that are irrevocably designated on initial recognition as at fair value
through profit or loss
4. All debt investments that do not satisfy the requirements for measurement at amortized
cost and at fair value through other comprehensive income
Financial Asset Held for Trading
Appendix A of PFRS 9 provides that a financial asset is held for trading if:
1. It is acquired principally for the purpose of selling or repurchasing it in the near term
2. On initial recognition, it is part of a portfolio of identified financial assets that are managed
together and for which there is evidence of a recent actual pattern of short-term profit
taking.
3. It is a derivative, except for a derivative that is a financial guarantee contract or a
designated and an effective hedging instrument.
In other words, trading securities are debt and equity securities that are purchased with the
intent of selling them in the near term or very soon.
Financial Assets at Fair Value through Other Comprehensive Income
At initial recognition, PFRS 9 paragraph 5.7.5, provides that an entity may make an
irrevocable election to present in other comprehensive income or OCI subsequent changes in fair
value of an investment in equity instrument that is not held for trading.
This irrevocable approach is designed to impose discipline in accounting for nontrading
equity investment.
The amount recognized in other comprehensive income is not reclassified to profit or loss
under any circumstances.
However, on derecognition, the amount may be transferred to retained earnings.
If the investment in equity instrument is held for trading, the election to present gain and
loss in other comprehensive income is not allowed.
If the investment in equity instrument is held for trading, subsequent changes in fair value
are always included in profit or loss or reported in the income statement.
Debt Investment at Amortized Cost
A financial asset shall be measured at amortized cost if both of the following conditions are
met: (PFRS 9, par.4.1.2)
1. The business model is to hold the financial asset in order to collect contractual cash flows
on specified dates.
2. The contractual cash flows are solely payments of principal and interest on the principal
amount outstanding.
Amortized cost is the initial recognition amount of the investment minus repayments, plus
amortization of discount, minus amortization of premium, and minus reduction for impairment and
uncollectibility. When bonds acquired are classified as financial asset at amortized cost, the bond
investments are classified as noncurrent investments.
Equity VS Debt Instruments
Only debt instruments can be classified under the Amortized Cost or FVOCI (mandatory)
measurement categories
Equity instruments are measured at FVPL, unless the entity makes an irrevocable election
on initial recognition to measure them at FVOCI
A debt instrument that is not measured at amortized cost or at FVOCI is measured at FVPL
Notes
If “hold to collect contractual cash flows” – at amortized cost
If “hold to collect contractual cash flows and to sell” – at FVOCI (with recycling – unrealized
gains or loss can be transferred to P/L)
If not, FVTPL
In other comprehensive income, it is not included in net income
Notes
If not “held for trading” and “FVOCI option elected” – at FVOCI (no recycling – unrealized
gains or loss cannot be transferred to P/L and will be closed to retained earnings)
If not, FVTPL
Reclassification
After initial recognition, financial assets are reclassified only when the entity changes its
business model for managing financial assets.
Reclassification date is the first day of the first reporting period following the change in
business model that results in an entity reclassifying financial assets.
Ex. Change in business model on June 1, 2020 while following the calendar year on January
1 to December 31, 2020. The next reporting period will be January 1 to December 31, 2021
following the change in business model, thus, the next reclassification date will be on January 1,
2021. If an entity is following the fiscal year – ex. July 1 to June 30, the next reclassification date will
be on July 1, 2020.
Notes on Reclassification
Only debt instruments can be reclassified. Equity instruments (e.g., investments in shares
of stocks) cannot be reclassified.
Financial assets cannot be reclassified into or out of the “designated at FVPL” and “FVOCI -
election” classifications.
The initial measurement is fair value at reclassification date, except for a reclassification
from FVOCI to Amortized cost where the fair value on reclassification date is adjusted for
the cumulative balance of gains and losses previously recognized in OCI.
Impairment
The impairment requirements of PFRS 9 apply equally to debt-type financial assets that are
measured either at amortized cost or at FVOCI.
Impairment gains or losses on debt instruments measured at FVOCI are recognized in profit
or loss. However, the loss allowance shall be recognized in other comprehensive income and shall
not reduce the carrying amount of the financial asset in the statement of financial position.
Dividends
Dividends received from equity securities measured at FVPL or FVOCI (except share
dividend) are recognized as dividend revenue.
