International Financial Reporting Standard (IFRS®) 9 Financial Instruments and International Accounting Standard (IAS®) 32 Financial Instruments: Presentation are complex standards, especially for users and preparers of financial statements. It is therefore no surprise that ACCA candidates also find them complex.
Both of these standards are relevant when accounting for financial instruments and they are both examinable in theFinancial Reporting (FR)exam. This articleprovides a high-level overview of the following financial instrument topics which these standards relate to:
- Financial assets
- Financial liabilities
- Convertible instruments
1.Financial assets
There are two types of financial asset which we will consider in this article – investments in equity and investments in debt instruments.
(a) Equity instruments
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 business model of the entity and the characteristics of the financial asset. 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) if an election is made. It is important to note that this election must be made on acquisition and is irrevocable so 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 (ie it is not held for trading).
Equity instruments: fair value through other comprehensive income (FVOCI)
Using FVOCI, the alternative elected treatment, transaction costs must 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 – the gain or loss is recognised within other comprehensive income and included as part of other components of equity in the statement of financial position. This might be referred to as an investment revaluation reserve or similar. In many ways it is like accounting for property, plant and equipment (PPE) using the revaluation model. However, unlike the treatment for a revaluation surplus related to PPE, there can be a negative (debit) balance on the investment revaluation reserve.
When the FVOCI instrument is sold, the reserve can be left in the investment revaluation reserve 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. There are three possible classifications for categorising debt instruments – amortised cost, FVOCI or FVPL.
The classification of an investment in debt instruments should be based on both:
(a) the entity’s business model for managing financial assets; and
(b) the contractual cash flow characteristics of the financial asset.
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 financial assets in order to collect the interest payments and receive repayment on maturity (ie the contractual cash flows).
- Contractual cash flow characteristics test– the contractual terms give rise to cash flows which are solely repayments of the interest and principal 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 requires candidates to demonstrate the principles of amortised cost accounting.
The principles of amortised cost accounting mean 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 or initial transaction costs were incurred. 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 finance income in two different ways. Firstly, they are earning the 5% payment each year. Secondly, they are earning another $1m over three years in the form of receiving more money back than they invested.
IFRS 9 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 and is known as the effective interest rate. Let’s say that in this example, the effective interest rate is 8.08%. This rate is applied to the outstanding balance each year in order to calculate the interest earned (finance income) on the investment, which is the amount to be recorded in finance 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 | Effective interest 8.08% | Receipt | Balance 31 Dec | |
20X1 | 10,000 | 808 | -500 | 10,308 |
20X2 | 10,308 | 833 | -500 | 10,641 |
20X3 | 10,641 | 859* | -500 | 11,000 |
* Note that the effective interest for 20X3 has been rounded slightly to arrive at the correct closing balance – remember that the initial principal of $10m plus an additional $1m at the end of the three-year loan period is being repaid.
The figures in the effective interest column would be the amounts recorded as finance 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 Loan receivable $10m, Cr Cash $10m.
The interest then accrues over the year at the effective interest rate of 8.08%. This increases the amount of the loan receivable and is recorded in finance income, so the entry is Dr Loan receivable $808k, Cr Finance 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 Loan receivable $500k.
The result of these entries is that the entity has a closing loan 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 Loan receivable $11m.
The total finance income 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 annual 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)
Another 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 objective of the entity’s business model is both to hold the financial assets in order to collect the contractual cash flows and also to sell the assets. This might include sales to manage liquidity needs or in order to maintain particular interest yields.
- 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 holds the debt instrument under the FVOCI category, they will still produce the amortised cost table as above, taking the same figure to finance income. At the year end, the asset would then be revalued to fair value, with the gain or loss being recorded in other comprehensive income and presented as an item that may be reclassified subsequently to profit or loss.
Debt instruments: fair value through profit or loss (FVPL)
Financial assets should be measured at FVPL unless they are measured at amortised cost or FVOCI. For example, an investment in debt instruments which is held for trading and therefore fails the business model test for amortised cost and FVOCI.
Financial assets measured at FVPL should be revalued at each year end with any revaluation gains or losses being recognised in the statement of profit or loss.
2. Financial liabilities
In the FR exam, financial liabilities will be held at amortised cost. This will be similar to the measurement treatment shown earlier for assets held under amortised cost. Instead of having finance 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 less 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. As noted earlier, the effective interest rate will be given to 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/repayment, 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 value (ie ‘nominal’ or ‘par’ value) of the instrument, so means that $500,000 will be payable annually (being 5% of $10m). Using the wrong figure here is a common mistake in the FR exam – the amount paid each year will remain the same throughout the life of the instrument and should not be calculated based on the carrying amount of the liability each year.
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 | Effective interest 8.85% | Payment | Balance 31 December | |
20X1 | 9,800 | 867 | -500 | 10,167 |
20X2 | 10,167 | 900 | -500 | 10,567 |
20X3 | 10,567 | 933* | -500 | 11,000 |
* Note that the effective interest for 20X3 has been rounded slightly to arrive at the correct closing balance.
The entries in 20X1 will be as follows:
1 January 20X1 – The loan note 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 Loan payable $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 Loan payable $867k.
31 December 20X1 – The payment of $500k is made, giving the entry Dr Loan payable $500k, Cr Cash $500k.
This leaves a closing liability of $10.167m. This will all be presented as a non-current liability, as none of it will be repayable until 31 December 20X3. It would be incorrect to split between a current and non-current component as you would do with a lease. In this example, at 31 December 20X2, £10.567m would be presented as a current liability as it will be repaid in the next 12 months.
If we look at the effective interest column, we will see that the total 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. In other words, they have been amortised (spread) over the life of the liability.
3. Convertible instruments
Convertible instruments are financial instruments which give the holder the right to either demand repayment of the principal amount or alternatively 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 on issue of a convertible instrument. They will usually take the form of convertible loan notes or convertible debentures (debt instruments).
Convertible instruments present a special challenge, as these could ultimately result in the issue of shares or the repayment of the loan note/debenture, but the choice will be in the hand of the loan note/debenture 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 by initially separating the instrument into equity and liability components and presenting each component on the statement of financial position accordingly.
The liability component is the first thing to calculate. We work this out by calculating the present value of the payments at themarket rateof interest (using the interest on an equivalent debt instrument 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 debt instrument. This is because the holder of the debt instrument is willing to accept a lower rate of annual interest compared to the market, in exchange for the option to convert the debt instrument 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 total cash received on issue and the calculated liability component.
EXAMPLE
Oviedo Co issued $10m 5% convertible loan notes on 1 January 20X1. These will either be repaid at par ($10m) on 31 December 20X3 or converted into 10 million ordinary $0.25 shares on that date. Equivalent loan notes without the conversion rights 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 |
2.723 | 2.577 |
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 – ie 8%. The only thing we need the 5% for is to work out the annual interest 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 was 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 | Discount factor 8% | Present value |
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 have an initial present 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.
