Module 08: Financial Instruments Framework

Financial Instrument
Generally Accepted Accounting Principles (GAAP) defines a financial instrument as cash,
evidence of an ownership interest in a company or other entity, or a contract that does
both of the following:
1. Imposes on one entity a contractual obligation either:
 To deliver cash or another financial instrument to a second entity
 To exchange other financial instruments on potentially unfavorable terms with the
second entity.
2. Conveys to that second entity a contractual right either:
 To receive cash or another financial instrument from the first entity
 To exchange other financial instruments on potentially favorable terms with the first
entity.
Financial instruments such as cash, accounts receivable and loans are a necessity of
operation and are required for sound fiscal management of any public sector entity.
Without financial instruments the operations of public sector entities – along with those of
private sector entities and citizens – would grind to a halt.
Financial instruments: is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity.
FINANCIAL INSTRUMENTS
FINANCIAL ASSETS FINANCIAL LIABILITY FINANCIAL EQUITY

Figure 1: Types of Financial Instruments

FINANCIAL ASSETS
A financial asset, simply put, is cash, an equity instrument of another entity, or a contract to
receive cash at a future date.
Common financial assets: The most commonly used financial assets are cash, or a contract
to receive cash.
These instruments are the lifeblood of any entity and are used in most routine transactions.
Common financial assets include:
 Accounts receivables;
 Loans receivable, including concessionary loans; and
 Investment certificates (Treasury Bills)
Not to be confused with financial assets: The following instruments are not financial
assets:
 Statutory receivables; and
 Prepaid balances
A financial asset is any asset that is:
a. cash;
b. an equity instrument of another entity;
c. contractual right:
 i. to receive cash or another financial asset from another entity; or ii. to
exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or
d. a contract that will or may be settled in the entity’s own equity instruments and
is:
i. a non-derivative for which the entity is or may be obliged to receive a
variable number of the entity’s own equity instruments; or
ii. a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s
own equity instruments. For this purpose the entity’s own equity
instruments do not include instruments that are themselves contracts for the
future receipt or delivery of the entity’s own equity instruments.
NONFINANCIAL ASSETS
Non-financial assets are entities, over which ownership rights are enforced by institutional
units, individually or collectively, and from which economic benefits may be derived by
their owners by holding them, or using them over a period of time, that consist of tangible
assets, both produced and non-produced, and most intangible assets for which no
corresponding liabilities are recorded.
A non-financial asset refers to an asset that is not traded on the financial markets, and its
value is derived from its physical characteristics rather than from contractual claims.
Examples of non-financial assets include tangible assets, such as land, buildings, motor
vehicles, and equipment, as well as intangible assets, such as patents, goodwill, and
intellectual property.
FINANCIAL LIABILITIES
A financial liability is a contractual obligation to deliver cash or another financial asset to
another entity.
Common financial liabilities: Similar to financial assets, many financial
liabilities are routinely used in daily transactions. Any time an entity has an obligation to
deliver cash, it has a financial liability. Common financial liabilities include:
 Bank overdraft;
 Accounts payable; and
 Borrowings (including bonds, loans and concessionary loans)
A financial liability is any liability that is:
a. a contractual obligation:
i. to deliver cash or another financial asset to another entity; or ii. to exchange
financial assets or financial liabilities with another entity under conditions that
are potentially unfavourable to the entity; or
b. a contract that will or may be settled in the entity’s own equity instruments and is:
i. a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entity’s own equity instruments; or
ii. a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s own
equity instruments. For this purpose the entity’s own equity instruments do not
 include instruments that are themselves contracts for the future receipt or
delivery of the entity’s own equity instruments.
EQUITY INSTRUMENTS
An equity instrument is any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities. Fair value is the amount for which an asset could
be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s
length transaction.
Hedge accounting
The objective of hedge accounting is to represent, in the financial statements, the effect of
an entity’s risk management activities that use financial instruments to manage
exposures arising from particular risks that could affect profit or loss or other
comprehensive income.
Hedge accounting is optional. An entity applying hedge accounting designates a hedging
relationship between a hedging instrument and a hedged item. For hedging relationships
that meet the qualifying criteria in IFRS 9, an entity accounts for the gain or loss on the
hedging instrument and the hedged item in accordance with the special hedge
accounting provisions of IFRS 9.
IFRS 9 identifies three types of hedging relationships and prescribes special accounting
provisions for each:
• fair value hedge: a hedge of the exposure to changes in fair value of a recognized
asset or liability or an unrecognized firm commitment, or a component of any such
item, that is attributable to a particular risk and could affect profit or loss.
• cash flow hedge: a hedge of the exposure to variability in cash flows that is
attributable to a particular risk associated with all, or a component of, a recognized
asset or liability (such as all or some future interest payments on variable-rate debt)
or a highly probable forecast transaction, and could affect profit or loss.  hedge of a
net investment in a foreign operation as defined in IAS 21.
INITIALRECOGNITIONAND MEASUREMENTOF FINANCIAL ASSETS
A financial asset shall be recognized in accounting when, and only when, an entity
receives or in accordance with the ongoing contract obtains a right to receive cash or
another financial asset. Forecast transactions and received guarantees are not recognized
as the entity’s assets as long as they do not meet the definition of financial assets.
At initial recognition, an entity shall measure a financial asset at its acquisition cost. The
acquisition cost of a financial asset might also include direct transaction costs.
Acquisition cost is determined on the basis of the amount of cash paid or payable for a
financial asset or the value of another delivered asset. If payment for a purchased asset is
deferred for a period longer than 12 months, and the interest rate is not prescribed by the
contract or it significantly differs from the market interest rate, the acquisition cost is
determined by discounting the total payable amount to the present value at the market
interest rate. The difference is recognized as interest expenses over the entire period of
repayment.
Acquisition cost of a financial asset received in an exchange transaction is determined by
adding all related transaction costs to the value prescribed by the exchange agreement. If t
he value of the asset is not prescribed by the exchange agreement, the acquisition cost of
the financial asset equals to the fair value of the financial asset given up in exchange.
INITIAL RECOGNITION AND MEASUREMENT OF FINANCIAL LIABILITIES
Financial liabilities shall recognized in accounting when, and only when, an entity
assumes an obligation to deliver cash or another financial asset. Forecast transactions
and originated financial guarantees that are not yet due are not recognized as the entity's
liabilities as long as they do not meet the definition of a financial liability.
At initial recognition, an entity shall measure a financial liability at cost, i.e., at the value
of the received asset or service. Related transaction costs shall be recognized as
expenses in the income statement in the same period when they are incurred.
The cost of a financial liability incurred in an exchange transaction is determined on the
basis of the value prescribed by the exchange agreement. If the exchange agreement does
not prescribe the value of the newly incurred liability, the cost of the financial liability
equals to the fair value of the financial liability given up in exchange.
FINANCIAL ASSETS and FINANCIAL LIABILITIES
CLASSIFICATION OF FINANCIAL ASSETS
The classification of financial assets is determined based on how an entity manages its
financial assets (its business model) and what the nature of the cash flows arising from the
financial assets is (contractual cash flow characteristics).
An entity’s business model is the manner in which an entity’s financial assets are managed
in order to generate cash flows. An entity may have more than one business model. The
business model does not depend on management’s intentions for an individual
instrument. The following diagram illustrates the three business models for classification
purposes of financial assets as well as the treatment of those financial assets:

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three_business_models.jpg
CLASSIFICATION OF FINANCIAL LIABILITIES
All financial liabilities will be classified at amortized cost (default category), except for:
 Financial liabilities at fair value through profit or loss (designated as such or held for
trading);
 Financial liabilities that arise when a transfer of a financial asset does not qualify for
derecognition or when the continuing involvement approach applies;
 Financial guarantee contracts; and
 Loan commitments to provide loans at below-market interest rates.
 Financial liabilities at fair value through profit or loss are those liabilities that are held for
trading. An entity may designate a financial liability at fair value through profit or loss if
doing so results in more relevant information, because either it eliminates or significantly
reduces an accounting mismatch, or a portfolio of financial liabilities is evaluated on a fair
value basis. This designation is irrevocable and must be made on initial recognition.
MEASUREMENT OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES
Initial measurement
All financial instruments are initially measured at fair value as per the requirements in
IFRS 13, except trade receivables that do not have a significant financing component.
Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement
date.
The fair value would normally be considered to be its quoted price, but a valuation
technique such as discounted cash flow may be used if the market for the instruments is
not active.
Transaction costs on all financial assets and liabilities are capitalized to the asset or liability,
except for financial assets and financial liabilities that are carried at fair value through profit
or loss, where they are accounted for as an expense.
Subsequent measurement
Financial assets and financial liabilities at amortized cost are subsequently carried at
amortized cost using the effective interest rate method. This method exactly discounts
estimated future cash receipts or payments to the gross carrying amount of a financial
asset or to the amortized cost of a financial liability.
Gains or losses arising from derecognition, reclassification, impairment or in the case of a
financial asset, the moralization process, will be recognized in profit or loss.
When the contractual cash flows of a financial asset are renegotiated or modified, the entity
will recalculate the present value using the financial asset’s original effective interest rate.
The modification gain or loss is recognized in profit or loss.
All financial assets and financial liabilities at fair value through profit or loss are carried at
fair value subsequent to initial recognition.
Fair value gains or losses (realized and unrealized) calculated on the subsequent
measurement are recognized in profit or loss.
For financial liabilities that have been elected into the fair value through profit or loss
category, the subsequent changes in fair value must be separated between those that result
from changes in credit risk, and other changes. The changes that result in credit risk must be
recognized in other comprehensive income and accumulated in equity. This separation is
not required if the financial liability is a loan commitment or financial guarantee contract, or
the separation would create or enlarge an accounting mismatch in profit or loss.
Financial assets at fair value through other comprehensive income are carried at fair value
subsequent to initial recognition, and all fair value gains and losses are recognized in other
comprehensive income.
When the financial asset is derecognized, the cumulative fair value gain or loss in equity
is recycled to profit or loss. However, those fair value gains or losses for financial assets
elected into the fair value through other comprehensive income category is never
recycled into profit or loss. The entity may transfer the cumulative gain or loss within
equity.
Impairment losses, foreign exchange differences and dividends are recognized in profit or
loss.
RECLASSIFICATIONS

An entity:

Shall not reclassify a derivative out of the fair value through surplus or deficit profit or loss
category while it is held or issued;
Shall not reclassify any financial instrument out of the fair value through surplus or deficit
profit or loss category if upon initial recognition it was designated by the entity as at fair
value through surplus or deficit profit or loss; and
May, if a financial asset is no longer held for the purpose of selling or repurchasing it in the
near term (notwithstanding that the financial asset may have been acquired or incurred
principally for the purpose of selling or repurchasing it in the near term), reclassify that
financial asset out of the fair value through surplus or deficit profit or loss category. An
entity shall not reclassify any financial instrument into the fair value through surplus or
deficit profit or loss category after initial recognition.
GAINS AND LOSSES
A gain or loss arising from a change in the fair value of a financial asset or financial
liability that is not part of a hedging relationship shall be recognized, as follows.
 A gain or loss on a financial asset or financial liability classified as at fair value
through surplus or deficit profit or loss shall be recognized in surplus or deficit profit
or loss.
 A gain or loss on an available-for-sale financial asset shall be recognized directly in
net assets/equity through the statement of changes in net assets/equity
DERECOGNITION
An entity shall derecognize a financial asset only when the contractual rights to the cash
flows expire or it transfers the financial asset and that transfer qualifies for derecognition.
An entity shall derecognize a financial liability only when it is extinguished i.e. when the
obligation specified in the contract is discharged or cancels or expires.
An exchange of debt instruments with substantially different terms between an existing
borrower and lender of debt, or a substantial modification to the terms of an existing
financial liability shall be accounted for as an extinguishment of the original financial
liability and the recognition of a new financial liability. The difference between the carrying
amount of a financial liability extinguished or transferred and the amount paid will be
recognized in profit or loss.