FINANCIAL ACCOUNTING & REPORTING 1

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Introduction to Financial Instruments

Module 003Introduction
Introduction to Financial
Instruments
A financial instrument is any contract that gives rise to a financial asset of
one entity and a financial liability or equity instrument of another entity.A
financial asset is any asset includes cash, an equity instrument of another
entity, a contractual right and a contract that will or may be settled in the
entity’s own equity instruments. A financial liability is any liability that is a
contractual
tractual obligation and a contract that will or may be settled in the
entity’s own equity instruments At initial recognition, an entity shall measure
a financial asset at fair value plus, in case of financial asset not at fair value
through profit or loss, transaction costs that are directly attributable to the
acquisition of the financial asset.
asset.Non-financial
financial assets include physical assets,
intangible assets, prepaid expenses and leased assets. Non-financial
Non liabilities
includes deferred revenue and warrant
warranty y obligations, income tax payable and
constructive obligations
At the end of this module, you will be able to
to:
1. Define financial instruments
2. Categorize financial assets / financial liabilities
3. Learn the approach in accounting for financial instruments
4. Identify
dentify non
non-financial assets / non-financial
financial liabilities
The common application of the lessons that are under this module consists of
being able to differentiate financial items from non-financial
financial items and
identify how to recognize them.

Definition of financial instruments

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

Thus, the term “financial instruments” encompasses a financial asset, financial liability and
an equity instrument.

The characteristics of a financial instrument are:

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.

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Introduction to Financial Instruments

Categories of financial assets / financial liabilities

Financial Asset - A financial asset is any asset that is:
(a) Cash
(b) An equity instrument of another entity
(c) A contractual
ual 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 favorable 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
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 subject to certain exclusions within IAS 32.

What is not a financial asset?

Physical assets — for example, inventories, proper
property,
ty, plant and equipment, commodities
(such as gold bullion), leased assets and intangible assets (such as servicing rights) are not
financial assets. Control of such physical and intangible assets creates an opportunity to
generate an inflow of cash or ano
another
ther financial asset, but it does not give rise to a present
right to receive cash or another financial asset. Likewise, assets, such as prepaid expenses
for which the future economic benefit is the receipt of goods or services, are not financial
assets.

Financial Liability - 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 unfavorable 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
derivative for which the entity is or may be obliged to deliver a variable
number of the eentity’s
ntity’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 subject to certain exclusions within
IAS 32.

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Introduction to Financial Instruments

What is not a financial liability?

A current tax payable, for example, is not considered a financial liability. Income taxes are
the result of statutory requirements imposed by governments and are not considered
contractual obligations. Similarly, constructive obligations do not arise from contracts and,
therefore, are not financial liabilities.

Financial assets covered by PAS 32 & 39

Cash - is described in IAS 7 Statement of Cash Flows as comprising cash on hand and
demand deposits. The purpose of cash is to pay off short term liabilities of the entity. IAS 32
explains that cash is a financial asset because it represents the medium of exchange and is,
therefore, the basis on which all ttransactions
ransactions 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
institution or to draw a cheque or similar instrument against the balance in favor of a
creditor in payment of a financial liability.

A certificate of deposit (CD) - is a savings certificate entitling the bearer to receive

interest. A CD bears a maturity date and a specified iinterest
nterest rate and can be issued in any
denomination. CDs are generally issued by commercial banks. Technically, a certificate of
deposit is a promissory note on which the borrower is a bank.

Commercial paper - is an unsecured, short

short-term
term corporate obligation
obligati usually issued at a
discount from face value. Because most commercial paper is unsecured, it is usually issued
by entities with investment
investment-grade credit ratings.

Convertible debt - is a debt instrument which can be converted, at a specified price, into
equity of the issuer. The conversion is at the holder’s option, and in most cases, convertible
securities are callable at a premium at the issuer’s option, beginning a few years after
issuance. Investors usually receive a lower coupon rate but the instrumentinstrume carries
additional value through the option to convert the debt to equity and thereby participating
in further growth in the entity’s equity value.

Preferred shares - usually provide a specific dividend that is paid before any dividends
are paid to ordinary
inary shareholders. The dividend rights are often cumulative, such that if the
dividend is not paid, it accumulates from year to year. Preferred shares usually carry no
voting rights but they take priority over ordinary shares in the event of liquidation. In
certain cases, preferred shares may have a convertibility feature into ordinary shares.

Financial instruments include a number of types of assets.

Medium-term notes - are debt instruments with maturities ranging between 5 to 10

years. Medium-term
term note
notess provide the issuer with flexibility in raising cash by, in effect,
arranging for long-term
term financing at short
short-term rates.

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A zero coupon debt instrument - is a bond with no periodic interest payments (that is,
coupons), issued at a substantial discount ffrom
rom face value. The holder of such a bond
receives a return by the gradual appreciation of the bond, which is redeemed at face value
at maturity. Issuers have the ability to raise cash without making current payments on the
bond and these are often used in leveraged buyouts where cash flows in the early years
may be critical.

Other financial assets excluded from the scope of PAS 39 and addressed under
other PFRS
IAS 32 and IAS 39 apply to all types of financial instruments, subject to certain scope
exclusions.
Subsidiaries, associates and joint ventures
Interests in subsidiaries, associates, and joint ventures that are accounted for under IFRS
10 Consolidated Financial Statements, IAS 27 Separate Financial Statements, IAS 28
Investments in Associates and Joint Ventures,, unless such Standards require the interest to
be accounted for under IAS 39. Derivatives on the above interests would also be accounted
for under IAS 39 regardless of how the investment is accounted for, unless the derivative
meets the definition
nition of an equity instrument of the entity under IAS 32
Leases
Rights and obligations under leases to which IAS 17 Leases applies are not within the scope
of IAS 32 but are within the scope of IAS 39 only to the following extent:
 Lease receivables and le
lease
ase payables are subject to the derecognition provisions in
IAS 39.
 Lease receivables are subject to the impairment provisions in IAS 39.
 Derivatives embedded within lease contracts are subject to the embedded
derivatives rules within IAS 39.
Employee benefit
nefit plans
Employers’ rights and obligations under employee benefit plans to which IAS 19 Employee
Benefits applies are not within the scope of IAS 32 or IAS 39.
Business Combinations
Forward contracts between an acquirer and a selling shareholder to buy or sell an acquiree
that will result in a business combination within the scope of IFRS 3 Business Combinations
at a future acquisition date. The term of the forward contract should not exceed a
reasonable period normally necessary to obtain any required aapprovals
pprovals and to complete
the transaction.
Share-Based
Based Payments
Financial instruments, contracts and obligations under share
share-based
based payment transactions
to which IFRS 2 Share-based
based Payment applies.

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IAS 37 Exceptions
Rights to payments to reimburse an entity for an expenditure it is required to make to
settle a liability recognized under IAS 37 Provisions, Contingent Liabilities and Contingent
Assets.
Equity Instruments
Financial instruments issued by the entity that meet the definition of an equity instrument
instrum
in IAS 32 or that are required to be classified as an equity instrument under IAS 32 are not
within the scope of IAS 39.
.
ADDITIONAL EXCEPTIONS
Insurance Contracts - Rights and obligations under insurance contracts as defined by
IFRS 4 Insurance Contracts are excluded from the scope of IAS 32 and IAS 39. However,
derivatives that are embedded in insurance contracts are within the scope of IAS 39 unless
the embedded derivative is itself an insurance contract under IFRS 4. IFRS 4 defines an a
insurance contract as “a contract under which one party accepts significant insurance risk
from another party by agreeing to compensate the policyholder if a specified uncertain
future event adversely affects the policyholder.” The scope exclusion applies
applie to contracts
that reimburse for a loss actually incurred.
Financial Guarantees - An issuer’s rights and obligations arising under an insurance
contract are also in the scope of IAS 39 where they meet the definition of a financial
guarantee contract. Howe
However,
ver, if an issuer of financial guarantee contracts has previously
asserted explicitly that it regards such contracts as insurance contracts and has used
accounting applicable to insurance contracts, the issuer may elect to apply either IAS 39 or
IFRS 4 to such financial guarantee contracts. The issuer may make that election contract by
contract, but the election for each contract is irrevocable. IAS 39 defines a financial
guarantee contract as “a contract that requires the issuer to make specified payments to
reimburse the holder for a loss it incurs because a specified debtor fails to make payment
when due in accordance with the original or modified terms of a debt instrument.”
Loan Commitments
Loan commitments are accounted for in accordance with IAS 37 unless (a) the entity has a
past practice of selling assets resulting from loan commitments shortly after origination or
(b) the commitment:
 Can be settled net (in cash or by some other financial instrument)
 Is issued at below
below-market interest rates
 Is designated
signated at fair value through profit or loss
If it meets one of these criteria, the loan commitment is within the scope of IAS 39.
A loan commitment is a firm commitment to provide credit under pre-specified
pre terms and
conditions.
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Introduction to Financial Instruments

All loan commitments ar

are subject to the de-recognition
recognition provisions of IAS 39.
Non-financial items
Non-financial
financial items normally are excluded from the scope of both IAS 32 and 39. However,
these Standards do apply to contracts to buy or sell non
non-financial
financial items that can be settled
net in cash or another financial instrument, or by exchanging financial instruments. Such
contracts are treated as if they were financial instruments, unless the contracts are entered
into and continue to be held for the purpose of the receipt or delivery of a non-financial
item in accordance with the entity’s expected purchase, sale or usage requirements (often
referred to as the ‘own use’ exception).

Scope exemption examples

Examples of the application of the scope exemptions are the following:
 Insurancece contracts: a Japanese subsidiary of Market Co enters into an insurance
policy with Insure Co to cover losses in the event of an earthquake in Japan. Insure Co is
only liable in case its customer (the Japanese subsidiary) incurs a loss due to an
earthquake.
ke. This loss is considered an identifiable insurable event and therefore is not
within the scope of IAS 32 or 39.
 Financial guarantee contracts: Ms. White is going to loan Mr. Smith 100,000. Ms.
White wants a credit guarantee from a bank as collateral for the loan. CMC Bank, Mr.
Smith’s bank, issues such a guarantee in favor of Ms. White for the loan. CMC Bank will
only pay the loss incurred by Ms. White because Mr. Smith does not repay his debt. The
credit guarantee meets the definition of a financial gua
guarantee
rantee contract, therefore it falls
within the scope of IAS 39 from CMC Bank’s perspective. The Bank may account for the
credit guarantee under IFRS 4 if it previously asserted explicitly that it regards such
contracts as insurance contracts.
 'Regular-way'' security transactions: a ‘regular way’ security transaction is a
transaction to purchase or sell a security under a contract whose terms require delivery
of the security within the time period that is customary for the exchange in which the
trade occurred.d. A regular way purchase or sale of financial assets is recognized using
either trade date accounting or settlement date accounting.
 Trade date and settlement date accounting: When trade date accounting is applied,
an entity recognizes an asset at the trade date. When settlement date accounting is
applied, an entity does not recognize an asset at the trade date, but instead accounts for
any change in the fair value of the asset to be received during the period between the
trade date and the settlement date in the same way it accounts for the acquired asset.
 Loan commitments: credit arrangements to consumers for residential mortgage loans
or committed borrowing facilities grante
granted to corporate entities
 Non-financial
financial items: a commodity (such as wheat or sugar) or other goods and
services (for example, inventory or telecommunication services)

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Introduction to Financial Instruments

Approach in accounting for financial instruments

Initial Measurement of Financial Assets
Under PFRS 9, paragraph B5.1.1, at initial recognition, an entity shall measure a financial
asset at fair value plus, in case of financial asset not at fair value through profit or loss,
transaction costs that are directly attributable to the acquisition of the financial asset.
The fair value of a financial instrument at initial recognition is normally the transaction
price, meaning the fair value of the consideration given.
In other words, a financial asset is recognized initially at fair value.
As a rule, transaction costs that are directly attributable to the acquisition of the financial
asset shall be capitalized as a cost of the financial asset.
However, if the financial asset is held for trading or if the financial asset is measured at fair
value through profit or loss, transaction costs are expensed outright.
This rule on outright expensing of transaction costs related to the financial asset held for
trading or financial asset at fair value through profit or loss (FVPL) is principally
prescriptivee rather than principle
principle-based.
Transaction costs include fees and commissions paid to agents, advisers, brokers, and
dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and
duties. It does not include debt premiums or disco
discounts,
unts, financing costs and internal
administrative or holding costs.
Subsequent Measurement
PFRS 9, paragraph 5.2.1 provides that after initial recognition, an entity shall measure a
financial asset either at fair value or amortized cost.
An entity shall subsequently
bsequently measure financial asset at fair value or amortized cost
depending on entity’s business model for managing financial assets.
The business model for managing financial assets may be:
a) To hold investments in order to realize fair value changes.
b) To hold
old investments in order to collect contractual cash flows

Reclassification
PFRS 9, paragraph 4.4.1, provides that an entity shall reclassify financial assets only when it
changes its business model for managing financial assets.

Non-financial assets / non

non-financial
financial liabilities: nature and examples
Non-financial assets

Physical Assets, such as inventory, property, plant and equipment, and intangible assets,
such as patents and trademarks, are not financial assets. Control of such physical and

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Introduction to Financial Instruments

intangible assets creates an opportunity to generate an inflow of cash or another financial

asset but it does not give rise to a present right to receive cash or another financial asset.

Assets, such as prepaid expenses

expenses,, for which the future economic benefit
bene is the receipt of
goods or services, rather than the right to receive cash or another financial asset, are not
also financial assets. Examples of prepaid expenses are prepaid insurance or prepaid
supplies.

Leased assets are not also financial assets b

because
ecause control of such assets does not give rise
to a present right to receive cash or another financial asset. Examples are leased equipment
and machineries.

Non-financial
financial liabilities

Deferred revenue and warranty obligations are not financial liabilities

liabiliti because the
outflow of economic benefits associated with them is the delivery of goods and services
rather than a contractual obligation to pay cash or another financial asset. Examples are
unearned interest income, unearned rental income, unearned subscription
subs revenue,
warranty for repairs or replacement of home appliances.

Liabilities, such as income tax payable

payable,, that are created as a result of statutory
requirements imposed by government are not also financial liabilities.

Constructive obligations are

re not financial liabilities because the obligations do not arise
from contracts. For example, an entity decides as a matter of policy to rectify faults in the
products even when these become apparent after the warranty period has expired.

Glossary
Certificate of deposit:: is a savings certificate entitling the bearer to receive interest.
Commercial paper: is an unsecured, short
short-term
term corporate obligation usually issued at a
discount from face value.
Convertible debt: is a debt instrument which can be converted, at a specified price, into
equity of the issuer.
Financial Instrument:: is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity.

References and Supplementary Materials

Books and Journals

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Introduction to Financial Instruments

1. Robles, N. S., &Empleo, P. M. (2014). Intermediate Accounting (2014 ed., Vol. 1).
Manila, Philippines.

2. Valix, C. T., Peralta, J. F., &Valix, C. M. (2017). Financial Accounting (2017 ed., Vol.
1).Manila,
anila, Philippines.

3. Valix, C. T., Peralta, J. F., &Valix, C. M. (2017). Financial Accounting (2017 ed., Vol.
2).Manila,
).Manila, Philippines.

4. IAS 32 – Financial Instruments: Presentation

5. IAS 39 – Financial Instruments: Recognition and Measurement

6. IFRS 7 – Financial Instruments: Disclosures

7. IFRS 9 – Financial Instruments

Online Supplementary Reading Materials

1. Financial Instruments;
http://www.ipsasb.org/projects/financial
http://www.ipsasb.org/projects/financial-instruments; 19 October
tober 2017

2. Accounting for Financial Instruments;

http://www.aicpa.org/interestareas/frc/accountingfinancialreporting/financialinstr
uments/pages/default.aspx
uments/pages/default.aspx; 19 October 2017

3. Recognition and Measurement of Financial Instruments;

http://www.fasb.org/jsp/FASB/Page/ImageBridgePage&cid=1176169269344
http://www.fasb.org/jsp/FASB/Page/ImageBridgePage&cid=1176169269344;
19 October 2017

Online Instructional Videos

1. Introduction to Financial Instruments;
https://www.youtube.com/watch?v=ms3QD_2RSIc
https://www.youtube.com/watch?v=ms3QD_2RSIc;; 18 October 2017

2. Introduction to Financial Instrum

Instruments in line with IFRS;
https://www.youtube.com/watch?v=x2SfwFyxdf8
https://www.youtube.com/watch?v=x2SfwFyxdf8;; 18 October 2017

3. Financial Instruments - Introduction;

https://www.youtube.com/watch?v=baMhHcGLeVs
https://www.youtube.com/watch?v=baMhHcGLeVs;; 18 October 2017

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