CHAPTER 26

PAS 32
FINANCIAL INSTRUMENTS-
PRESENTATION
 Technical knowledge
• To define financial instrument
• To define financial asset, financial liability
and equity instrument
• To know the guideline when an instrument
is a financial liability or an equity instrument
• To know the recognition of a compound
financial instrument
 Financial instrument
• PAS 32, paragraph 11, defines a financial
instruments as any contract that gives rise to
both a financial asset od 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 a financial
instrument
a.There must be a contract
b.There are at least two parties to the
contract
c.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- this
is a financial asset of the holder or bearer
and a financial liability of the issuing
government.

Cash in the form of checks- this is a

financial asset of the payee and a financial
liability of the drawer or issuer.
Cash in bank- this is a financial asset of the
depositor and a financial liability of depository
bank.

Trade accounts- this is a financial asset of

the seller as accounts receivable and a
financial liability of the customer or buyer as
accounts payable.
Note and loan- this is a financial asset of the
lender or creditor as note receivable or loan
receivable and a financial liability of the borrower
or debtor as note payable or loan payable.

Debt security- this is a financial asset of the

investor and a financial liability of the issuer.

Equity security- this is a financial asset of the

investor and equity of the issuer.
 Examples of financial assets

• Cash or currency is a financial asset

because it represents the medium of
exchange and is therefore the basis on
which all transactions are measured and
recognized in financial statements.
• A deposit of cash with a bank or similar
financial institution is a financial asset because it
represents the contractual right of the depositor to
obtain cash from the bank or to draw a check
against the balance in favor of a creditor in
payment of a financial liability.
Financial assets representing a contractual
right to receive cash in the future include:

a.Trade accounts receivable

b.Notes receivable
c.Loans receivable
d.Bonds receivable
 Nonfinancial assets
a. Physical assets, such as inventory and property,
plant and equipment
b. Intangible assets, such as patent and trademark
c. Prepaid expenses for which the future economic
benefit is the receipt of goods or services, rather
than the right to receive cash or another financial
asset.
d. 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.
 Financial liability
A financial liability is any liability that is a
contractual obligation:
a.To deliver cash or other financial asset to
another entity.
b.To exchange financial instruments with
another entity under conditions that are
potentially unfavorable.
Examples of financial
liabilities

a.Trade accounts payable

b.Notes payable
c.Loans payable
d.Bonds payable
 Nonfinancial liabilities
a. 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.
b. Income tax payable is not a financial liability
because it is imposed by law and non contractual.
c. Constructive obligations are not financial liabilities
because the obligations do not arise from contract.
 Equity instruments

• The definition of an equity instrument is

very brief and succinct. It reflects the basic
accounting equation that equity equals
asset minus liability.
• An equity instrument is any contract that
evidences a residual interest in the assets
of an entity after deducting all of the
liabilities.
 When liability and when equity

PAS 32, paragraph 15, provides that the

issuer of a financial instrument shall classify
the instruments 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.
Redeemable preference share

a. 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.
b. 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.
 Compound financial
instrument
PAS 32, paragraph 28, defines a compound
financial instrument as “a financial
instrument that contains both a liability and
an equity element from the perspective of
the issuer.”
 Common examples of
compound financial
instrument
• Bonds payable issued with share
warrants
• Convertible bonds payable
 Accounting for compound
instrument
• The issuer of a financial instrument shall evaluate
the terms of the instrument whether it contains both
a liability and an equity component.
• If the financial instrument contains both a liability
and an equity component, PAS 32 mandates that
such components shall be accounted for separately.
• The approach in accounting for a compound
financial instrument is known as “split accounting.”
• This means that the consideration received from
the issuance of the compound financial instrument
shall be allocated between the liability and equity
components.

• The fair value of the liability component is then

deducted from the total consideration received
from the issuance of the compound financial
instrument.
 Bonds payable issued with share
warrants
• When the bonds are sold with share
warrants, the bondholders are given the right to
acquire shares of the issuer at a specified price
at some future time.
• Actually, in this case, two securities are sold-
the bonds and the share warrants.
• Share warrants attached to a bond may be
detachable or non detachable.
• Detachable warrants can be traded
separately from the bond and non
detachable warrants cannot be traded
separately.

• Whether detachable of non detachable,

the warrants have a value and therefore
shall be accounted for separately.
 Allocations of issue price
• The bonds are assigned an amount equal
to the “market value of the bonds ex-
warrants”, regardless of the market value of
the warrants.
• The residual amount or remainder of the
issue price shall then be allocated to the
warrants.
For example, an entity issued bonds with face amount of
P5,000,000 at 105. Each P1,000 bond is accompanied by
one warrant that permits the bondholder to purchase 20
shares, par P50, at P55 per share.
The market value of the bond ex-warrant at the time of the
issuance is 98.
Issue price of bonds with warrants
(5,000,000 x 105%) 5,250,000
Market value of bonds ex-warrants-liability
(5,000,000 x 98%) (4,900,000)
Residual amount allocated to share
warrants-equity 350,000
 Convertible bonds
• An entity frequently makes its bond issue
more attractive to investors by making the
bonds convertible.

• Generally, an entity can obtain financing at

a lower interest rate by issuing convertible
bond.
 Allocation of issue price
• The bonds are assigned on amount equal
to the market value of the bonds without the
conversion privilege.

• The residual amount or remainder of the

issue price shall then be allocated to the
conversion privilege or equity component.
For example, an entity issued bonds with face amount of
P5,000,000 at 105. The bonds contain a conversion
privilege that provides for an exchange of a P1,000 bond
for 20 shares with par value of P50.
It is reliably determined that the bonds would sell only at 95
without the conversion privilege.
Total issue price (5,000,000 x 105%) 5,250,000

Issue price of bonds without conversion

privilege (5,000,000 x 95%) (4,750,000)

Residual amount allocated to

conversion privilege-equity 500,000
 QUESTIONS
1. Define a financial instrument
2. Define a financial asset
3. Give examples of financial asset
4. Define a financial liability
5. Give examples of financial liability
6. Define an equity instrument
7. What is the guideline in determining whether a financial instrument
is a financial liability or an equity instrument?
8. Explain a redeemable preference share
9. Explain the accounting for a compound financial instrument
10.Explain the accounting for bonds payable issued with share
warrants and convertible bonds.
 Problem 26-1 Multiple Choice
(PAS 32)
1.A financial instrument is any contract that
gives rise to
a.A financial asset
b.A financial liability
c. A financial asset of one entity and a financial
liability of another entity
d.A financial asset of one entity and a financial
liability or equity instrument of another entity.
 Problem 26-1 Multiple Choice
(PAS 32)
2. Which is not classified as a financial
instrument?

a.Convertible bond
b.Foreign currency contract
c.Warranty provision
d.Loan receivable
 Problem 26-1 Multiple Choice
(PAS 32)
3. Which cannot be considered a financial
asset?
a.Cash
b.A contractual right to receive cash or another
financial asset from another entity.
c. A contractual right to exchange financial
instruments with another entity under
conditions that are potentially unfavorable
d.An equity instrument of another entity.
 Problem 26-1 Multiple Choice
(PAS 32)
4. Which should be classified as financial
asset?

a.Patent
b.Trade accounts receivable
c.Inventory
d.Land
 Problem 26-1 Multiple Choice
(PAS 32)
5. A financial liability
a.Must be classified as noncurrent liability.
b.Is a contractual obligation to deliver cash or
another financial asset to another entity.
c. Is a contractual obligation to exchange
financial instrument with another entity under
conditions that are potentially favorable to the
entity.
d.Is a contractual obligation to deliver cash or
any asset to another entity.
 Problem 26-1 Multiple Choice
(PAS 32)
6. Financial liabilities include all of the
following, except

a.Trade accounts payable

b.Notes payable
c.Bonds payable
d.Income tax payable
 Problem 26-1 Multiple Choice
(PAS 32)
7. It is any contract that evidences
residual interest in the assets of an entity
after deducting all of the liabilities.
a.Equity instrument
b.Debt instrument
c.Loan receivable
d.Financial asset with indeterminable fair
value.
 Problem 26-1 Multiple Choice
(PAS 32)
8. How should preference shares that are
redeemable mandatorily be presented in
the statement of financial position?
a.Noncurrent liability
b.Current liability
c.Equity
d.Either current or noncurrent liability
depending on redemption date
 Problem 26-1 Multiple Choice
(PAS 32)
9. What is the presentation of the
preference dividend on mandatorily
redeemable preference shares?
a.Deducted from retained earnings
b.Deducted from share premium
c.Interest expense
d.Deducted from share capital
 Problem 26-1 Multiple Choice
(PAS 32)
10. Which is not an equity instrument?

a.Ordinary share capital

b.Bonds payable
c.Preference share capital
d.Share option or warrant
 Problem 26-2 Multiple Choice
(PAS 32)
1. What is the principal accounting for a compound instrument?

a. The issuer shall classify a compound instrument as either a liability

or equity based on evaluation of the predominant characteristics of
the contractual arrangement.
b. The issuer shall classify the liability and equity components of a
compound instrument separately as liability or equity.
c. The issuer shall classify a compound instrument as an equity in the
entirety.
d. The issuer shall classify a compound instrument as a liability in the
entirety, until converted equity.
 Problem 26-2 Multiple Choice
(PAS 32)
2. How are the proceeds from the issuing a compound instrument
allocated between the liability and equity components?
a. First, the liability component is measured at fair value, and then the
remainder of the proceeds is allocated to the equity component.
b. First, the equity component is measured at fair value, and then the
remainder of the proceeds is allocated to the liability component.
c. First, the fair values of both the equity component as the liability
component are estimated. Then the proceeds are allocated to the
liability and equity components based on the relation between the
estimated fair value.
d. The equity component is measured at its intrinsic value. The liability
component is measured at the face amount less the intrinsic value
of the equity component.
 Problem 26-2 Multiple Choice
(PAS 32)
3. Which bonds are issued with share warrants,
the equity component is equal to

a. Zero
b. The excess of the proceeds over the face
amount of the bonds.
c. The market value of the share warrants
d. The excess of the proceeds over the fair value of
the bonds without the share warrants.
 Problem 26-2 Multiple Choice
(PAS 32)
4. When bonds are issued with share warrants,
a portion of the proceeds should be allocated
to equity when the bonds are issued with

a. Detachable share warrants

b. Non detachable share warrants
c. Both detachable and non detachable share
warrants
d. Neither detachable nor non detachable share
warrants
 Problem 26-2 Multiple Choice
(PAS 32)
5. The proceeds from an issue of bonds payable with
share warrants should not be allocated between the
liability and equity components when

a. The fair value of the warrants is not readily available.

b. The exercise of the warrants within the next reporting
period seems remote.
c. The warrants issued are non detachable.
d. The proceeds should be allocated between liability and
equity under all of these circumstances.
 Problem 26-3 Multiple Choice
(PAS 32)
1. A bond convertible by the holder into a
fixed number of ordinary shares of the
issuer is
a.A compound financial instrument
b.A primary financial instrument
c.A derivative financial instrument
d.An equity instrument
 Problem 26-3 Multiple Choice
(PAS 32)
2. Convertible bonds
a.Have priority over other indebtedness
b.Are usually secured by a mortgage
c.Pay interest only in the event net
income is sufficient
d.May be exchanged for shares of the
issuer
 Problem 26-3 Multiple Choice
(PAS 32)
3. Convertible bonds
a.Are separated into liability and expense
b.Allow an entity to issue debt financing at
lower rate
c.Are separated into liability and equity
components based on fair value
d.Are not accounted for as compound
instrument
 Problem 26-3 Multiple Choice
(PAS 32)
4. What is the accounting for issued
convertible bond?
a. The instrument should be recorded solely as
bond
b. The instrument should be recorded as either
bond or equity but not both
c. The instrument should be recorded solely as
equity
d. The instrument should be recorded as part bond
and part equity.
 Problem 26-3 Multiple Choice
(PAS 32)
5. Issued convertible bonds are
a.Separated into liability and equity with the
liability recorded at fair value and the
residual assigned to the equity
b.Always recorded using fair value
c.Recorded at face amount for the liability
d.Recorded at par value of the shares