What is a financial instrument?

Let us start by looking at the definition of a financial instrument, which is that a

financial instrument is a contract that gives rise to a financial asset of one entity and a

financial liability or equity instrument of another entity.

 

With references to assets, liabilities and equity instruments, the statement of financial

position immediately comes to mind. Further, the definition describes financial

instruments as contracts, and therefore in essence financial assets, financial liabilities

and equity instruments are going to be pieces of paper.

 

For example, when an invoice is issued on the sale of goods on credit, the entity that

has sold the goods has a financial asset – the receivable – while the buyer has to

account for a financial liability – the payable. Another example is when an entity raises

finance by issuing equity shares. The entity that subscribes to the shares has a

financial asset – an investment – while the issuer of the shares who raised finance has to account for an equity instrument – equity share capital. A third example is when an entity raises finance by issuing bonds (debentures). The entity that subscribes to the bonds – ie lends the money – has a financial asset – an investment – while the issuer of the bonds – ie the borrower who has raised the finance – has to account for the bonds as a financial liability.

 

So when we talk about accounting for financial instruments, in simple terms what we

are really talking about is how we account for investments in shares, investments in

bonds and receivables (financial assets), how we account for trade payables and

long-term loans (financial liabilities) and how we account for equity share capital

(equity instruments). (Note: financial instruments do also include derivatives, but this

will not be discussed in this article.)

 

In considering the rules as to how to account for financial instruments there are

various issues around classification, initial measurement and subsequent

measurement.

 

This article will consider the accounting for equity instruments and financial liabilities.

Both arise when the entity raises finance – ie receives cash in return for issuing a

financial instrument. A subsequent article will consider the accounting for financial

assets.

 

Distinguishing between debt and equity

For an entity that is raising finance it is important that the instrument is correctly

classified as either a financial liability (debt) or an equity instrument (shares). This

distinction is so important as it will directly affect the calculation of the gearing ratio,

a key measure that the users of the financial statements use to assess the financial

risk of the entity. The distinction will also impact on the measurement of profit as the

finance costs associated with financial liabilities will be charged to the income

statement, thus reducing the reported profit of the entity, while the dividends paid on

equity shares are an appropriation of profit rather than an expense.

 

When raising finance the instrument issued will be a financial liability, as opposed to

being an equity instrument, where it contains an obligation to repay. Thus, the issue

of a bond (debenture) creates a financial liability as the monies received will have to

be repaid, while the issue of ordinary shares will create an equity instrument. In a

formal sense an equity instrument is any contract that evidences a residual interest in

the assets of an entity after deducting all of its liabilities.

 

It is possible that a single instrument is issued that contains both debt and equity

elements. An example of this is a convertible bond – ie where the bond contains an

embedded derivative in the form of an option to convert to shares rather than be

repaid in cash. The accounting for this compound financial instrument will be

considered in a subsequent article.

 

Equity instruments

Equity instruments are initially measured at fair value less any issue costs. In many

legal jurisdictions when equity shares are issued they are recorded at a nominal value, with the excess consideration received recorded in a share premium account and the

issue costs being written off against the share premium.

 

Example 1: Accounting for the issue of equity

Dravid issues 10,000 $1 ordinary shares for cash consideration of $2.50 each. Issue

costs are $1,000.

 

Required

Explain and illustrate how the issue of shares is accounted for in the financial

statements of Dravid.

 

Solution

The entity has raised finance (received cash) by issuing financial instruments.

Ordinary shares have been issued, thus the entity has no obligation to repay the

monies received; rather it has increased the ownership interest in its net assets. As

such, the issue of ordinary share capital creates equity instruments. The issue costs

are written off against share premium. The issue of ordinary shares can thus be

summed up in the following journal entry.

Equity instruments are not remeasured. Any change in the fair value of the shares is

not recognised by the entity, as the gain or loss is experienced by the investor, the

owner of the shares. Equity dividends are paid at the discretion of the entity and are

accounted for as reduction in the retained earnings, so have no effect on the carrying

value of the equity instruments.

 

As an aside, if the shares being issued were redeemable, then the shares would be

classified as financial liabilities (debt) as the issuer would be obliged to repay back

the monies at some stage in the future.

 

Financial liabilities

A financial instrument will be a financial liability, as opposed to being an equity

instrument, where it contains an obligation to repay. Financial liabilities are then

classified and accounted for as either fair value through profit or loss (FVTPL) or at

amortised cost.

 

Financial liabilities at amortised cost

The default position is, and the majority of financial liabilities are, classified and

accounted for at amortised cost.

 

Financial liabilities that are classified as amortised cost are initially measured at fair

value minus any transaction costs.

 

Accounting for a financial liability at amortised cost means that the liability's effective

rate of interest is charged as a finance cost to the income statement (not the interest

paid in cash) and changes in market rates of interest are ignored – ie the liability is

not revalued at the reporting date. In simple terms this means that each year the

liability will increase with the finance cost charged to the income statement and

decrease by the cash repaid.

 

Example 2: Accounting for a financial liability at amortised cost

Laxman raises finance by issuing zero coupon bonds at par on the first day of the

current accounting period with a nominal value of $10,000. The bonds will be

redeemed after two years at a premium of $1,449. The effective rate of interest is 7%.

 

Required

Explain and illustrate how the loan is accounted for in the financial statements of

Laxman.

 

Solution

Laxman is receiving cash that it is obliged to repay, so this financial instrument is

classified as a financial liability. There is no suggestion that the liability is being held

for trading purposes nor that the option to have it classified as FVTPL has been made,

so, as is perfectly normal, the liability will be classified and accounted for at

amortised cost and initially measured at fair value less the transaction costs. The

bonds are being issued at par, so there is neither a premium or discount on issue.

Thus Laxman initially receives $10,000. There are no transaction costs and, if there

were, they would be deducted. Thus, the liability is initially recognised at $10,000.

 

In applying amortised cost, the finance cost to be charged to the income statement is

calculated by applying the effective rate of interest (in this example 7%) to the

opening balance of the liability each year. The finance cost will increase the liability.

The bond is a zero coupon bond meaning that no actual interest is paid during the

period of the bond. Even though no interest is paid there will still be a finance cost in

borrowing this money. The premium paid on redemption of $1,449 represents the

finance cost. The finance cost is recognised as an expense in the income statement

over the period of the loan. It would be inappropriate to spread the cost evenly as this

would be ignoring the compound nature of finance costs, thus the effective rate of

interest is given. In the final year there is a single cash payment that wholly

discharges the obligation. The workings for the liability being accounted for at

amortised cost can be summarised and presented as follows.

Accounting for financial liabilities is regularly examined in both Paper F7 and Paper

P2 so let's have a look at another, slightly more complex example.

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