Financial Instruments (IFRS 9 and IAS 32)

IAS 32 Financial Instruments: Presentation defines financial instruments and covers the distinction between debt and equity. IFRS 9 Financial Instruments covers classification, measurement, impairment, and hedge accounting. IFRS 7 covers disclosures.

Financial instrument: A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial asset: Any asset that is:

• Cash
• An equity instrument of another entity (e.g., shares held in another company)
• A contractual right to receive cash or another financial asset (e.g., trade receivables, loans advanced, bonds held)
• A contractual right to exchange financial assets or liabilities on potentially favourable terms (e.g., derivative contracts)

Financial liability: Any liability that is a contractual obligation to deliver cash/another financial asset or to exchange on potentially unfavourable terms (e.g., trade payables, loans, bonds issued, derivative liabilities).

Equity instrument: Any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities (e.g., ordinary shares).

Debt vs equity (IAS 32): The classification depends on the substance of the contractual arrangement, not its legal form. Key test: does the entity have a contractual obligation to deliver cash or another financial asset? If yes → liability. If the instrument includes a right of the issuer to avoid delivering cash → equity. Example: a preference share that is redeemable at the holder's option is a liability (not equity) because the issuer cannot avoid cash outflow.

IFRS 9 classifies financial assets into three categories based on TWO tests: (1) the business model for managing the asset, and (2) the contractual cash flow (SPPI) characteristics.

Test 1 — Business model test: How does the entity manage its financial assets to generate cash flows? Three business models:

• Hold to collect: The objective is to hold the asset to collect contractual cash flows
• Hold to collect and sell: The objective is both to collect cash flows and to sell the asset
• Other: Neither of the above (e.g., held for trading, managed on a fair value basis)

Test 2 — SPPI test (Solely Payments of Principal and Interest): Do the contractual cash flows represent solely payments of principal and interest on the principal amount outstanding? Interest = consideration for time value of money and credit risk. If cash flows include other elements (e.g., equity returns, linked to commodity prices), the SPPI test fails.

Equity instruments (shares held in other companies): Default classification is FVTPL. However, an entity can make an irrevocable election at initial recognition to classify non-trading equity investments at FVOCI. For FVOCI equity investments: fair value changes go to OCI, dividend income goes to P/L, and gains/losses are NOT recycled through P/L on disposal (they stay in equity — often transferred to retained earnings).

Fair value option: An entity may irrevocably designate a financial asset at FVTPL at initial recognition if doing so eliminates or significantly reduces an accounting mismatch.

Initial measurement: At fair value plus (for assets not at FVTPL) transaction costs directly attributable to acquisition. For FVTPL assets: transaction costs are expensed immediately.

Subsequent measurement — Amortised cost (effective interest method):

• The effective interest rate (EIR) is the rate that exactly discounts estimated future cash payments/receipts to the gross carrying amount of the asset (or amortised cost of the liability)
• Interest income = gross carrying amount × EIR (for assets). Interest expense = amortised cost × EIR (for liabilities).
• The EIR takes account of all transaction costs, premiums, discounts, and fees that are integral to the instrument
• The carrying amount of the asset/liability is updated each period: interest added, payments/receipts deducted

Example of EIR mechanics: An entity acquires a 3-year bond with face value £100,000 for £95,000. The bond pays 5% coupon annually on the face value (£5,000/year) and is redeemed at face value. The EIR is calculated so that the PV of cash flows (£5,000, £5,000, £105,000) equals £95,000 at initial recognition. This gives an EIR of approximately 6.85%. Interest income each year = opening carrying amount × 6.85%.

IFRS 9 replaced the incurred loss model (under IAS 39) with a forward-looking expected credit loss (ECL) model. Credit losses must be recognised even before any loss event has occurred — based on expectations of future defaults.

Scope: The ECL model applies to financial assets measured at amortised cost and FVOCI debt instruments, plus loan commitments, financial guarantee contracts, and contract assets under IFRS 15. It does NOT apply to FVTPL assets or equity investments.

Two approaches:

1. General approach (three-stage model):

Significant increase in credit risk (transfer from Stage 1 to Stage 2): Assessed using quantitative (e.g., downgrade in credit rating, increase in probability of default) and qualitative (e.g., economic deterioration, adverse changes in payment behaviour) indicators. Rebuttable presumption: credit risk has increased significantly when payments are more than 30 days past due.

Default presumption: A financial asset is in default when payments are more than 90 days past due — unless the entity has reasonable information to rebut this presumption.

2. Simplified approach:

• Mandatory for trade receivables and contract assets without a significant financing component
• Optional for trade receivables and contract assets with a significant financing component, and lease receivables
• Always measure at lifetime ECL — no need to track significant increases in credit risk (no stage 1 vs 2 distinction)
• Typically use a provision matrix: group receivables by customer segment and ageing (0-30 days, 31-60, 61-90, 90+), apply historical loss rates adjusted for forward-looking information (e.g., economic forecasts)

Measuring ECL: ECL = PV of cash shortfalls, weighted by probability of default. Must consider:

• Probability-weighted outcomes (not just best or worst case)
• Time value of money (discount at original EIR)
• Reasonable and supportable information about past events, current conditions, and forecasts of future economic conditions

Derecognition of financial assets: A financial asset is derecognised when either:

• The contractual rights to cash flows expire (e.g., bond matures and is repaid); OR
• The entity transfers the financial asset AND the transfer qualifies for derecognition

Transfer qualifies for derecognition if the entity has transferred substantially all the risks and rewards of ownership. If the entity has retained substantially all the risks and rewards, the asset is NOT derecognised (e.g., factoring with full recourse — the entity retains the credit risk, so the receivables remain on the balance sheet; the cash received is a secured loan).

If risks and rewards are neither transferred nor retained, assess whether control has passed. If control has been transferred, derecognise. If control has been retained, continue to recognise the asset to the extent of the entity's continuing involvement.

Derecognition of financial liabilities: A financial liability is derecognised when the obligation is discharged, cancelled, or expires. A substantial modification of the terms of a liability (new terms differ by ≥10% of the PV of cash flows) is treated as derecognition of the old liability and recognition of a new one — with any difference to P/L.

Financial liabilities are classified as either:

1. Amortised cost (default category):

• Measured at amortised cost using the effective interest method
• Includes: trade payables, bank loans, bonds issued, lease liabilities (under IFRS 16)
• Interest expense based on the EIR — reflecting all transaction costs and premiums/discounts

2. Fair value through profit or loss (FVTPL):

• Mandatorily: held-for-trading liabilities, derivative liabilities
• Optionally (fair value option): if it eliminates an accounting mismatch, or if managed on a fair value basis, or if contains an embedded derivative
• Subsequent measurement: fair value with changes to P/L
• Own credit risk: For financial liabilities designated at FVTPL under the fair value option, the portion of the fair value change attributable to changes in the entity's own credit risk is generally presented in OCI (not P/L). This prevents the counterintuitive outcome of an entity reporting a gain in P/L when its own credit deteriorates.

Financial guarantee contracts and loan commitments at below-market rates: Initially measured at fair value. Subsequently measured at the higher of: (a) the ECL loss allowance, or (b) the amount initially recognised less cumulative income recognised.

Some financial instruments contain both debt and equity components — a compound instrument. The most common example is a convertible bond: a bond that the holder can convert into a fixed number of shares at a future date.

Split accounting: IAS 32 requires the issuer to separate the debt and equity components at initial recognition. The method is:

1. Measure the liability (debt) component first at its fair value — the PV of the future cash flows (coupon payments + redemption at maturity) discounted at the market rate of interest for a similar non-convertible bond
2. The equity component is the residual — total proceeds less the fair value of the liability component

Subsequent measurement:

• The liability component is subsequently measured at amortised cost using the market rate (EIR) — interest expense each year is higher than the cash coupon because it includes the unwinding of the discount
• The equity component is NOT remeasured — it stays at its initial amount in equity

On conversion: The carrying amount of the liability is transferred to equity (to share capital and share premium). No gain or loss is recognised on conversion. The original equity component remains in equity.

On redemption without conversion: The redemption payment is allocated to the liability and equity components using the same method as at initial recognition. Any difference between allocated amount and carrying amount: for the liability component → P/L; for the equity component → equity.

Hedge accounting is an optional accounting treatment that matches the timing of gains/losses on a hedging instrument (typically a derivative) with the timing of gains/losses on the hedged item — reducing volatility in P/L that would otherwise arise from applying normal accounting.

Qualifying criteria for hedge accounting:

• The hedging relationship consists of eligible hedging instruments and eligible hedged items
• At inception, there is formal designation and documentation (risk management objective, hedging instrument, hedged item, nature of risk, method for assessing effectiveness)
• The hedging relationship meets the effectiveness requirements: economic relationship, effect of credit risk not dominating, hedge ratio reflects the quantities actually used

Three types of hedges: