Republic of the Philippines

MARINDUQUE STATE COLLEGE

School of Business and Management
Bachelor of Science in Accountancy

MODULE 9
PAS 32
FINANCIAL INSTRUMENTS – PRESENTATION
LEARNING OBJECTIVES:
After studying this module, you should be able to:
1. define financial instrument
2. define financial asset, financial liability and equity instrument
3. know the recognition of a compound financial instrument

FINANCIAL INSTRUMENT
PAS 32, paragraph 11, defines a financial instrument as any contract that gives rise to both a financial
asset of one entity and a financial liability or equity instrument of another entity.
Thus, the term “financial instrument” encompasses a financial asset, a financial liability or equity
instrument of another entity.
Characteristics of a financial instrument
a. There must be a contract.
b. There are at least two parties to the contract.
c. The contract shall give rise to a financial asset of one party and financial liability or equity
instrument of another party.

Examples of financial instrument

a. Cash in the form of notes and coins – This is a financial asset of the holder or bearer and a financial
liability of the issuing government.
b. Cash in the form of checks – This is a financial asset of the payee and a financial liability of the
drawer or issuer.
c. Cash in bank – This is a financial asset of the depositor and a financial liability of the depository
bank.
d. Trade accounts – This is a financial asset of the seller as accounts receivable and a financial liability
of the customer or buyer as accounts payable.
e. Note and loan – This is a financial asset of the lender or creditor as note receivable or loan
receivable and a financial liability of the borrower or debtor as note payable or loan payable.
f. Debt security – This is a financial asset of the investor and a financial liability of the issuer.
g. Equity security – This is a financial asset of the investor and an equity of the issuer.

Examples of financial assets

Cash or currency is a financial asset because it represents the medium of exchange and is therefore the
basis on which all transactions are measured and recognized in financial statements.
A deposit of cash with a bank or similar financial institution is a financial asset because it represents
the contractual right of the depositor to obtain cash from the bank or to draw a check against the
balance in favor of a creditor in payment of a financial liability.
But a gold bullion deposited in bank is not a financial asset because although it is very precious the
gold is a commodity.
Financial assets representing a contractual right to receive cash in the future include:

Conceptual Framework and Accounting Standards Mark Rey U. Tan, CPA, MSA Page 1 of 5
 Republic of the Philippines
MARINDUQUE STATE COLLEGE
School of Business and Management
Bachelor of Science in Accountancy

a. Trade accounts receivable

b. Notes receivable
c. Loans receivable
d. Bonds receivable

In case of exchanges of financial instruments with another entity, conditions are potentially favorable
when such exchanges will result to gain or additional cash inflow to the entity.
Conversely, conditions are unfavorable when such exchanges will result to loss or additional cash
outflow to the entity.
An example of a favorable condition is an option held by the holder to purchase shares of another
entity at less than market price.
Investments in shares or other equity instruments issued by other entities, for example, trading
securities, can be classified as financial assets.
Nonfinancial assets
a. Physical assets, such as inventory and property, plant and equipment
b. Intangible assets, such as patent and trademark
c. Prepaid expenses for which the future economic benefit is the receipt of goods or services, rather
than the right to receive cash or another financial asset.
d. Right of use asset or leased asset is not a financial asset because control of the underlying asset
does not give rise to a present right to receive cash or another financial asset.

Financial liability
A financial liability is any liability that is a contractual obligation:
a. To deliver cash or other financial asset to another entity.
b. To exchange financial instruments with another entity under conditions that are potentially
unfavorable.

Examples of financial liabilities

a. Trade accounts payable
b. Notes payable
c. Loans payable
d. Bonds payable

Nonfinancial liabilities
a. Deferred revenue and warranty obligations are not financial liabilities because the outflow of
economic benefits is the delivery of goods and services rather than a contractual obligation to pay
cash.
b. Income tax payable is not a financial liability because it is imposed by law and non-contractual.
c. Constructive obligations are not financial liabilities because the obligations do not arise from
contract.

Equity instrument
The definition of an equity instrument is very brief and succinct. It reflects the basic accounting
equation that equity equals asset minus liability.
An equity instrument is any contract that evidences a residual interest in the assets of an entity after
deducting all of the liabilities.

Conceptual Framework and Accounting Standards Mark Rey U. Tan, CPA, MSA Page 2 of 5
 Republic of the Philippines
MARINDUQUE STATE COLLEGE
School of Business and Management
Bachelor of Science in Accountancy

Equity instruments include ordinary share capital preference share capital and warrants or option.
When liability and when equity
PAS 32, paragraph 15, provides that the issuer of a financial instrument shall classify the instrument as
a financial liability or equity instrument as a financial liability or equity instrument in accordance with
the substance of the contractual arrangement and the definition of a financial liability, financial asset
and equity instrument.
Paragraph 16 further provides that to determine whether a financial instrument is an equity
instrument rather than a financial liability, the instrument is an equity instrument if the instrument
includes no contractual obligation to deliver cash or another financial asset.
Redeemable preference share
a. A preference share that provides for mandatory redemption by the issuer for a fixed or
determinable amount at a future date is a financial liability of the issuer because the issuer has a
contractual obligation to pay cash at some future time.
b. A preference share that gives the holder the right to require the issuer to redeem the instrument
at particular date for affixed or determinable amount is also a financial liability because the issuer
has a contractual obligation to pay cash at some future time.

Accordingly, dividends paid to holders of “mandatorily redeemable preference share” shall be

accounted for as interest expense.
The mandatorily redeemable preference share shall be classified as current or noncurrent liability
depending on the date of redemption.
Compound financial instrument
PAS 32, paragraph 28, defines a compound financial instrument as “a financial instrument that
contains both a liability and an equity element from the perspective of the issuer.”
In other words, one component of the financial instrument meets the definition of a financial liability
and another component of the financial instrument meets the definition of an equity instrument.
Common examples of compound financial instrument are:
a. Bonds payable issued with share warrants
b. Convertible bonds payable

Accounting for compound instrument

The issuer of a financial instrument shall evaluate the terms of the instrument whether it contains
both a liability and an equity component.
If the financial instrument contains both a liability and an equity component, PAS 32 mandates that
such components shall be accounted for separately.
The approach in accounting for a compound financial instrument is known as “split accounting”.
This means that the consideration received from the issuance of the compound financial instrument
shall be allocated between the liability and equity components.
In other words, the fair value if the liability component is first determined.
The fair value of the liability component is then deducted from the total consideration received from
the issuance of the compound financial instrument.
The residual amount is allocated to the equity component.

Conceptual Framework and Accounting Standards Mark Rey U. Tan, CPA, MSA Page 3 of 5
 Republic of the Philippines
MARINDUQUE STATE COLLEGE
School of Business and Management
Bachelor of Science in Accountancy

Bonds payable issued with share warrants

When the bonds are sold with share warrants, the bondholders are given the right to acquire shares of
the issuer at a specified price at some future time.
Actually, in this case, two securities are sold – the bonds and the share warrants.
Share warrants attached to a bond may be detachable or nondetachable.
Detachable warrants can be traded separately from the bond and nondetachable warrants cannot be
traded separately.
PAS 32 does not differentiate whether the equity component is detachable or nondetachable.
Whether detachable or nondetachable, the warrants have a value and therefore shall be accounted
for separately.
Allocation of issue price
The bonds are assigned an amount equal to the “market value of the bonds ex-warrants”, regardless
of the market value of the warrants.
The residual amount or remainder of the issue price shall then be allocated to the warrants.
For example, an entity issued bonds with face amount of P5,000,000 at 105. Each P1,000 bond is
accompanied by one warrant that permits the bondholder to purchase 20 shares, par P50, at P55 per
share.
The market value of the bond ex-warrant at the time of issuance is 98.
Issue price of bonds with warrants (5,000,000 x 105%) 5,250,000
Market value of bonds ex-warrants – liability
(5,000,000 x 98%) (4,900,000)
Residual amount allocated to share warrants – equity 350,000

Convertible bonds
An entity frequently makes its bonds issue more attractive to investors by making the bonds
convertible.
Generally, an entity can obtain financing at a lower interest rate by issuing convertible bond.
Convertible bonds give the holders the right to convert their bond holdings into share capital of the
issuing entity within a specified period of time.
Convertible bonds are conceived as compound financial instruments.
Accordingly, the issuance of convertible bonds shall be accounted for as a partly liability and partly
equity.
In other words, the issue price of the convertible bonds shall be allocated between the bonds payable
and the conversion privilege.
Allocation of issue price
The bonds are assigned on amount equal to the market value of the bonds without the conversion
privilege.
The residual amount or remainder of the issue price shall then be allocated to the conversion privilege
or equity component.
For example, an entity issued bonds with face amount of P5,000,000 at 105. The bonds contain a
conversion privilege that provides for an exchange of a P1,000 bonds for 20 shares with par value of
P50.
It is reliably determined that the bonds would sell only at 95 without the conversion privilege.
Total issue price (5,000,000 x 105%) 5,250,000
Conceptual Framework and Accounting Standards Mark Rey U. Tan, CPA, MSA Page 4 of 5
 Republic of the Philippines
MARINDUQUE STATE COLLEGE
School of Business and Management
Bachelor of Science in Accountancy

Issue price of bonds without conversion privilege

(5,000,000 x 95%) (4,750,000)
Residual amount allocated to conversion privilege – equity 500,000

CONGRATULATIONS! YOU HAVE COMPLETED MODULE 9.

CHILLAX KA MUNA WHILE WAITING FOR MODULE 10.

Reference:
Valix C., J. Peralta, and C.A. Valix (2019). Conceptual Framework and Accounting
Standards – 2019 Edition.

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