Financial Instrument

(Long Term Debt and Investment)

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 Basic Concepts and Terminologies

Financial instrument
Any contract that gives rise to:
• A financial asset of one entity; and
• A financial liability or equity instrument of another entity

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 Basic Concepts and Terminologies

 Financial asset
• Cash
• A contractual right to receive cash or another financial asset
• A contractual right to exchange financial assets or liabilities with another
entity on potentially favourable terms
• An equity instrument (e.g. Ordinary shares of another entity).
• Example: Cash, A/c Receivable, Notes Receivable, derivatives, investments

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 Basic Concepts and Terminologies

 Financial liability
• A contractual obligation to deliver cash or another financial asset
• A contractual obligation to exchange financial assets or liabilities with
another entity on potentially unfavourable terms.
• Example: a/c payable, notes payable, bank overdraft, loans payable, certain
preference shares, derivatives
 Equity instrument
• A contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
• Example: Ordinary shares, certain preference shares
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BASIC CONCEPTS AND TERMINOLOGIES

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 Initial Recognition

An entity shall recognise a financial asset/liability in its statement of financial

position [SOFP] when, and only when, the entity becomes party to the

contractual provisions of the instrument as a consequence, has a legal right to

receive/pay cash or another financial instrument.

Contract Period

Beginning of contract End of contract

Compare this with the recognition criteria for non-financial assets.

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INITIAL RECOGNITION

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 Classification of Financial Assets

The initial as well as subsequent measurement of financial assets is subject to their

classification.
Classification category
1. Financial assets measured at FVTPL
2. Financial assets measured at fair value through other comprehensive income
(FVTOCI)
 with gains and losses remaining in other comprehensive income (OCI) without
subsequent reclassification to profit or loss.
 with cumulative gains and losses reclassified to profit or loss upon
derecognition.
3. Financial assets measured at amortised cost

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 Classification/Measurement Bases
of Financial Assets

Criteria
I. Business Model Test

Hold to collect Other business

Hold to collect
and Sell model
Cash flows are solely
payments of principal
II.Cash and interest (SPPI)
Flows Amortised cost FVOCI FVTPL
Test

Other types of cash

FVTPL FVTPL FVTPL
flows

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 Initial Measurement 10

 Transaction costs: fees and commission paid to agents, advisers, brokers and
dealers, levies by regulatory agencies and security exchanges, and transfer
taxes and duties
Adjusted for
transaction costs

Initial Initial
Initial =
carrying carrying
carrying Fair value
amount amount
amount

Asset or Liability Asset Liability

Measured Measured
Measured at
at other at other
FVTPL
than FVTPL than FVTPL 10
 Measurement at Initial Recognition

 Initial recognition = fair value + transaction costs

 Transaction costs include:
 Fees and commissions
 Levies by regulatory agencies and securities exchanges
 taxes and duties
 Transaction costs do not include:
 Debt premiums or discounts
 Financing costs
 Internal administrative costs
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 Initial Measurement

 Fair value versus transaction price

 Best evidence of the fair value of a financial instrument at initial recognition is
normally the transaction price.
 If fair value at initial recognition differs from transaction price recognise (day 1) the
difference between the fair value at initial recognition and the transaction price as a
gain or loss if fair value is evidenced by:
i. a quoted price in an active market for an identical asset or liability (i.e. Level 1); or
ii.based on valuation technique that uses only data from observable markets (i.e.
some Level 2)
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 Subsequent Measurement of Financial Asset
Amortised Cost (Debt Instruments)

Other
Statement of
Profit or loss Comprehensive
financial position
Income
Interest revenue using
effective interest method

Impairment
Amortised cost Nil
Foreign exchange gains &
losses
Gain or loss on
derecognition

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 Debt Instruments

Non-current liabilities (long-term debt) consist of an

expected outflow of resources arising from present
obligations that are not payable within a year or the
operating cycle of the company, whichever is longer.
Examples: ► Pension liabilities
► Bonds payable ► Lease liabilities
► Long-term notes payable
► Mortgages payable Long-term debt has various covenants
or restrictions.
 Issuing Bonds

 Bond contract known as a bond indenture.

 Represents a promise to pay:
(1) sum of money at designated maturity date, plus
(2) periodic interest at a specified rate on the maturity
amount (face value).
 Paper certificate, typically a €1,000 face value.
 Interest payments usually made semiannually.
 Used when the amount of capital needed is too large for one
 Valuation of Bonds Payable @ Issuance

Issuance and marketing of bonds to the public:

 Usually takes weeks or months.
 Issuing company must
► Arrange for underwriters.
► Obtain regulatory approval of the bond issue, undergo
audits, and issue a prospectus.
► Have bond certificates printed.
 Valuation of Bonds Payable

Selling price of a bond issue is set by the

 supply and demand of buyers and sellers,
 relative risk,
 market conditions, and
 state of the economy.

Investment community values a bond at the present value of its

expected future cash flows, which consist of (1) interest and (2)
principal.
 Valuation of Bonds Payable

Interest Rate
 Stated, coupon, or nominal rate = Rate written in the terms
of the bond indenture.
► Bond issuer sets this rate.
► Stated as a percentage of bond face value (par).

 Market rate or effective yield = Rate that provides an

acceptable return commensurate with the issuer’s risk.

► Rate of interest actually earned by the bondholders.

 Valuation of Bonds Payable

How do you calculate the amount of interest that is actually paid to

the bondholder each period?
(Stated rate x Face Value of the bond)

How do you calculate the amount of interest that is actually

recorded as interest expense by the issuer of the bonds?
(Market rate x Carrying Value of the bond)
 Valuation of Bonds Payable

Assume Stated Rate of 8%

Market Interest Bonds Sold At

6% Premium

8% Par Value

10% Discount
 Types of Bonds

 Debenture bonds. Debenture bonds are bonds that are not secured by specific property.
Their marketability is based on the general credit rating of the company. Generally, a
company must have a long-period of earnings and continued favorable predictions of
future earnings and liquidity to sell debenture bonds. Debenture bondholders are
considered to be general creditors, with the same rights as other creditors if the issuer
fails to pay the interest or principal and declares bankruptcy.
 Mortgage Bonds. Mortgage bonds are bonds that are secured by a lien against specific
property of the company. If the company becomes bankrupt and is liquidated, the holders
of these bonds have first claim against the proceeds of the sale of the assets that secured
their debt. If the proceeds from the sale of pledged assets are not sufficient to repay the
debt, mortgage bondholders become general creditors for the balance of the unpaid
debt.
 Registered Bonds. Registered bonds are bonds whose ownership is registered
with the company. That is, the company maintains a record of the holder of
each bond. Therefore, on each interest payment date, interest is paid to the
individuals listed on the corporate records as owners of the bonds. When an
owner sells registered bonds, the issuer or transfer agent must be notified so
that interest will be paid to the proper person.

 Coupon Bonds. Coupon bonds are unregistered bonds on which interest is

claimed by the holder presenting a coupon to the company. These bonds can
be transferred between individuals without the company or its agent being
notified.
 Zero-Coupon Bonds. Zero-coupon bonds (also called deep-discount bonds) are bonds on
which the interest is not paid until the maturity date. That is, the bonds are sold at a price
considerably below their face value, interest accrues until maturity, and then the
bondholders are paid the interest along with the principal at maturity.

 Callable Bonds. Callable bonds are bonds that are callable by the company at a
predetermined price for a specified period. That is, the company has the right to require
the bondholders to return the bonds before the maturity date, with the company paying
the predetermined price and interest to date.
 Convertible Bonds. Convertible bonds are bonds that are convertible into a
predetermined number of shares. That is, the owner of each bond has the right to
exchange it for a
predetermined number of shares of the company. Thus, upon conversion, the bondholder
becomes a stockholder of the company.
 Serial Bonds. Serial bonds are bonds issued at one time, but portions of the total face
value mature in periodic installments at different future dates. Bonds with several
maturities.
 Term Bonds. Term bonds are bonds that pay the entire principal on one date, i.e. at the
maturity date. Bonds with single maturity.
 Income (Revenue) Bonds. These are bonds whose payment of interest is conditional on income.
 Subsequent Measurement of Financial Asset
Fair Value Through OCI (FVOCI Debt Instruments)

Statement of
Other Comprehensive
financial Profit or loss
Income
position
Interest revenue using Fair value change other
effective interest method than those recognised in
profit or loss

Fair value Impairment

(amounts accumulated
Foreign exchange gains are recycled to P&L
& losses upon derecognition)

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 Subsequent Measurement of Investments in
Equity Instruments
Determining the accounting for interests in other entities
(Interaction of IFRS 10, 11, 12 and IAS 28)
Outright control?
Yes No

Consolidation (IFRS 10) Joint control?

Yes No

Determine type of joint arrangement Significant influence?

(IFRS 11)
Yes No

Joint Operation Joint Venture

Financial asset
Account for assets, liabilities, revenues and Equity accounting accounting (IAS
expenses (IFRS 11) (IAS 28) 39/IFRS 9)

IFRS 12 IFRS 7 26
 Subsequent Measurement of Investments in
Equity Instruments

Fair value through OCI (investments in equity instruments)

Statement of
Other Comprehensive
financial Profit or loss
Income
position

Changes in fair value and

foreign exchange component

Fair value Dividends

(amounts accumulated never
recycled to P&L → may be
transferred within equity)

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 Subsequent Measurement of Investments in
Equity Instruments

Fair value through profit or loss

Statement of financial Other comprehensive

Profit or loss
position income (OCI)

Changes in Fair
value
Fair value Nil
Gain or loss on
derecognition

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 Derecognition of Financial Assets

 Removal of a previously recognised financial asset from an entity’s statement of financial position.
A financial asset is derecognized when and only when:
1. The contractual rights to the cash flows from the financial asset expire; or
2. The financial asset is transferred and the transfer qualifies for derecognition.
A financial asset is transferred when:
An entity transfers the contractual rights to receive the cash flows of the financial asset, or
An entity retains the contractual rights to receive the cash flows of the financial asset, but assumes
a contractual obligation to pay the cash flows to one or more recipients (pass through of cash flows);
Transfer of financial asset qualifies for derecognition:
if the entity transfers substantially all the risks and rewards of ownership of the financial asset, or
if the entity has not retained control
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 Derecognition of Financial Assets 30

Continuing
Continued recognition involvement

No Yes
Yes
Have Have rights Obligatio Transferred Retained
rights to No to cash No n to ‘pass Yes substantiall No substantiall No Retained
cash flows been through’ y all risks y all risks control of
flows transferred of cash and and the asset?
expired? ? flows rewards? rewards?

Yes Yes Yes No

Derecognition

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 Derecognition of Financial Assets
Cases
1. A company sells an investment in shares, but retains the right to repurchase the
shares at any time at a price equal to their current fair value.
(Derecognise the asset. )
2. If the company sells an investment in shares and enters into an agreement whereby
the buyer will return any increases in value to the company and the company will
pay the buyer interest plus compensation for any decrease in the value of the
investment.
( Do not derecognise the asset as it has retained substantially all the risks and
rewards.) 31
 Disclosure

 The purpose of disclosures prescribed by IFRS 7 is to assist users in assessing the

nature and extent of risks related to financial instruments: Qualitative &

Quantitative Disclosures about:
 Market risk

 Credit risk

 Liquidity risk

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