Financial Instrument

TANZANIA INSTITUTE OF ACCOUNTANCY
MWANZA CAMPUS
BACHELOR OF ACCOUNTANCY III - BAC. III
ACU 08105: FINANCIAL REPORTING
FINANCIAL INSTRUMENTS
There are 4 reporting standards that deal with financial instruments

i. IAS 32 Financial Instruments presentation
ii. IAS 39 Financial Instrument Recognition and Measurements
iii. IFRS 7 Financial Instruments Disclosure
iv. IFRS 9 Financial Instruments
Objective
The objective of these standards is to establish principles for classifying financial instruments
into the following heading
 Financial assets
 Financial liabilities
 Equity instruments
The standard also gives definition for some important terms in this area
KEY DIFINITION IN THIS STANDARD
1. Financial Instrument
Is any contract that gives rise to a financial asset of one entity and financial liability or
equity instrument of another entity.
Clarification of the definition
The definition describes financial instruments as a contract, and therefore financial
instruments are going to be piece of paper.
Example
 When an invoice is issued on the sale of goods on credit the entity that has sold
the goods has a financial asset (receivable) while the buyer has to account for a
financial liability (payable)
 When an entity raises finance by issuing equity share the entity that subscribes
(buy/acquire) to the shares has the financial assets while the issuer of the shares
has to account for equity instruments
 When an entity raise finance by issuing bond, the entity that subscribes/buy to
the bond (lending the money) has the financial assets while the issuer of the bond
(the borrower) has the financial liability
 When a person deposit cash in the bank account has the right to receive the cash
in the future (financial assets) while the bank has the obligation to repay the
cash in the future (financial liability)
To conclude when we talk about financial instrument we really talking about
Financial assets eg investment bonds, receivable cash etc
Financial liabilities eg long term loans, trade payable etc
Equity instrument eg equity share
Test your understanding
Identify which of the following are financial instruments
I. Inventory
II. Investment in ordinary share
III. Prepayment for goods or service
IV. Liability for income taxes.
Initial and subsequent measurement of financial instruments

1. Equity instruments
1
i. Initial measurement
Equity instrument are initially measured at fair value less any issue cost.
In practice equity share when issued are recorded at nominal value with excess
consideration received recorded in a share premium account and the issue cost
being written off against the share premium.
ii. Subsequent measurement
Equity share in the books of issuer are not re-measured. Any change in the fair
value of shares is not recognized by entity as gain or loss is recognized by the
investor (the owner of the share)
Example
David plc issues 10,000 Tshs 1 ordinary shares for cash consideration of Tshs2.50 each. Issue
costs are Tshs1,000
Required
Explain and illustrate how the issue of share is accounted for in the financial statements of
David plc.
2. Financial liability
For the purpose of initial and subsequent measurement financial liabilities are classified
as
a) Financial liability at amortized cost
b) Financial liability at fair value through profit or loss
I. Financial liability at amortized cost
Initial measurement
These are initial measured at fair value less transaction costs. Example if the fair value
is Tshs 10,000/= and issue cost id Tshs 1,000 then the initial carrying value will be
10,000-1,000= 9,000.
Subsequent measurement
A financial liability at amortized cost will be measured subsequently at amortized cost.
Note; at amortized cost means at each year end the liability will be increased with the
finance cost charged on the outstanding balance of the liability at start of the year, and
decreased by the cash repaid.
Example
A company issue 4% loan notes with a nominal value of Tshs20,000. The loan notes are
issued at a discount of 2.5% and Tshs534 of the issue cost are incurred. The loan notes
will be repayable at a premium of 10% after 5 years. The effective rate of interest is 7%.
Assume the loan notes are carried at amortized cost.
a) What amount will be recorded as a financial liability when the loan notes are
issued?
b) What amount will be shown in the income statement and statement of financial
position for year 1-5?
II. Financial liabilities at fair value through profit or loss

1. Financial liabilities are only classified as Fair value through profit or loss if they
are held for trading or the entity so chooses.
Initial measurement
Financial liability at fair value through profit or loss are measured at fair value and any
transaction cost are immediately written off to the statement of profit or loss
Example
A company issued a 3 years 5% Tshs 30,000 loan note at nominal value. Issuing cost is
Tshs3,000.
Required
Calculate the amount for initial measurement
Solution
Initial measurement = fair value = 30,000
2
Transaction cost of Tshs 3,000 will be immediately charged to the statement of profit or
loss and not deducted in the fair value of loan.
Financial liability at fair value through profit or loss are subsequently measured at each
reporting date at fair value with any gain/loss recognized in the statement of profit or
loss
Financial assets
For initial and subsequent measurement financial assets are classified as
a) Financial assets at amortized cost
b) Financial assets at fair value through profit or loss
c) Financial assets at fair value through other comprehensive income
Financial assets at amortized cost
Initial measurement
= fair value (purchase consideration) plus transaction cost if any
Financial assets at amortized cost are subsequently measured at amortized cost
Example
A company invests Tshs5,000 in 10% debentures. The debentures are repayable at premium
after 3 years. The effective interest rate is 12%
Required
Show the amount that will be reported in the income statement and statement of financial
position for the financial asset for years 1-3.
Financial assets at fair value through profit or loss

Initial measurement
Financial assets at fair value through profit or loss are measured at fair value and any
transaction cost are immediately written off to the statement of profit or loss
Financial assets at fair value through profit or loss are subsequently measured at each
reporting date at fair value with any gain/loss recognized in the statement of profit or loss
Financial assets at fair value through other comprehensive income

Initial measurement
Financial assets at fair value through other comprehensive income are measured at fair value
plus any transaction cost. Fair value + transaction cost
Financial assets at fair value through other comprehensive income are subsequently measured
at each reporting date at fair value with any gain/loss recognized in the statement of other
comprehensive income
In practice the assets classified under this category are those not held for trading purpose.
Example
A company purchase 500 shares for Tshs 12 millions the company incurred blocker fee of Tshs
120,000.
Required
Show journal entries if the investment is classified as
a. Fair value through profit or loss
b. Fair value though other comprehensive income
Test your understanding
Air South Pacific plc incurred the following financial assets and liabilities during the year 20X7
1) Purchase of a debt security for Tshs25 millions with the transaction cost of Tshs 0.2
millions. The debt security is held for trading purposes.
3
2) Equity shares purchased for Tshs4 millions. The dealer fee paid was Tshs0.7 million.
ASP select to classify these shares as financial asset at fair value through profit or loss
3) During the year ASP purchase a bond of Tshs10 millions at a premium of Tshs0.1
millions and classified it as at amortized cost sale. Transaction cost incurred on the
bond were Tshs0.15 millions
4) ASP issued a bond for Tshs600millions and incurred issuance cost of Tshs1.2 millions.
This bond was measured at amortized cost by ASP.
Required
As ASP accountant, determine the initial carrying amount of each of the above financial
instruments.
Presentation of financial instruments

When an entity issues a financial instrument, it should classify it according to the substance of
the contract under which it has been issued.
It should be classified as
a) Financial liability
b) Financial asset
c) An equity instruments
Specific scenarios
1. Preference share
Preference shares provide the holder with the right to receive an annual dividend out of
the profit of the company together with the fixed amount on liquidation of the company.
The legal form of this instrument is an equity but in substance.
 Fixed level of dividend is interest
 And redemption amount is the repayment of loan
Therefore it follows that
 Redeemable preference shares are classified as financial liability
 Irredeemable preference shares are classified as equity
2. Compound/hybrid financial instruments
A compound or hybrid financial instruments is the one that contain both a liability
component and equity component.
Example is a convertible bond
Here the issuer of a convertible bond has
 The obligation to pay annual interest and eventually repay the capital of the
liability
 The possibility of issuing equity, should the bond holder choose the conversion
option
 In substance the issue of such a bond is the same as issuing separately a non
convertible bond and an option to purchase share.
 At the date of issue, the component of such instrument should be classified
separately according to their substance. The amount received on the issue (net of
transaction cost) should be allocated as follows
i. The fair value of liability component measured as the present value of the
periodical interest repayment and the eventual capital repayment,
assuming the bond is redeemable
ii. The fair value of the equity component measured as the remainder i.e
Equity element = Net proceeds – Liability element calculated in (i) above
Example
A company issues 2% convertible bonds at their nominal value of Tshs 36,000. The bonds are
convertible at any time up to maturity into 120 ordinary shares for each Tshs 100 of bond.
Alternatively the bonds will be redeemed at par after 3 years. Similar non convertible bonds
would carry an interest rate of 9%. The present value based on rates of 2% and 9% are as
follows
YEAR 2% 9%
4
1 0.98 0.92
2 0.96 0.84
3 0.94 0.77
What amounts will be shown as financial liability and as equity when the convertible
bonds are issued?
What amounts will be shown in the income statement and statement of financial position
for year 1-3?
Example
In 1 October 2010 Alpha issued 50 million loan notes of Tshs 1 each at par. The annual interest
payable on these notes is 5cents per note, payable in arrears. These notes are redeemable at par
on 30 September 2015 or convertible (at the option of the note holder) into equity shares on that
date. On 1 October 2010 investors in loan notes with no conversion option would have required
an annual rate of return of 8%. On 1 October 2010 the director of Alpha included Tshs 50
millions in long term borrowings in respect of the loan notes. The actual interest paid of Tshs
2.5 millions was charged as a finance cost in Alpha’s income statement for the year ended 30
September 2011. Relevant discount factor are as follows
5% 8%
Present value of Tshs 1 payable at the end of the year 5 78.4cents 68.1cents
Cumulative present value of Tshs 1 payable at the end of year 1-5 Tshs4.33 Tshs3.99
Required
Show the statement of financial position valuation of loan at 30 September 2011

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TANZANIA INSTITUTE OF ACCOUNTANCY

There are 4 reporting standards that deal with financial instruments

Initial and subsequent measurement of financial instruments

II. Financial liabilities at fair value through profit or loss

Financial assets at fair value through profit or loss

Financial assets at fair value through other comprehensive income

Presentation of financial instruments

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