Financial instruments: recognition and measurement

Question 1

Objective and scope of IAS 32 Financial
Instruments: Presentation and IFRS 9 Financial
Instruments

Answer 1

Objective
 The use of financial instruments by businesses for funding, investment and risk
management purposes is an essential part of operations.
 The use of financial instruments, especially derivatives, although providing
solutions to financial management, can significantly change the risk profile of
organisations.
 This change in risk may not be obvious to management, shareholders or other
stakeholders of a company. The accounting standards therefore need to
present the potential rewards and risk exposure from financial instruments in
the financial statements of a company.
1.2 Scope
These standards apply to all types of financial instruments and entities, with the
exception of:
 Interests in subsidiaries, associates or joint ventures accounted for under
another standard
 Rights and obligations under pension schemes
 Share-based payment transactions.

Question 1

IAS 32: Financial Instruments:
Presentation

Answer 1

2.1 Definitions
‘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.’ (IAS 32, para 11)

Financial asset
Cash
A contractual right to receive cash
A contractual right to exchange financial assets/financial liabilities on favourable terms
An equity instrument in another entity.

Financial liability
A contractual obligation to deliver cash
A contractual obligation to exchange financial assets/liabilities on unfavourable terms.

Equity instrument
Residual interest in the net assets of an entity without any contractual obligations.

Question 2

Financial instruments:2.2 Substance of transactions

Answer 2

The presentation of a financial instrument is determined by the
definition and the substance of the transaction. The key factor is
whether the contract contains an obligation to transfer cash or another
financial instrument.

Question 3

Financial Financial instruments:2.2 Substance of transactions  Preference shares:

Answer 3

 Preference shares:
– Redeemable –the entity has an obligation to redeem the shares.
Therefore, recognise as financial liabilities.
– Irredeemable – the entity has no obligation to redeem and therefore
recognise as equity unless there is a mandatory obligation to pay a
dividend. In this case the irredeemable preference shares will be treated
as a financial liability.

Question 4

Financial instruments:2.2 Substance of transactions
:  Convertible instruments:

Answer 4

– Convertible instruments have features of both equity and financial
liabilities.
– Need to split into component parts – the present value of the amount
repayable is calculated to represent the fair value of the financial liability.
The difference between this fair value of the financial liability and the value
of the entire instrument is shown as equity.
– After initial recognition the liability element is accounted for at amortised
cost using the effective interest rate. The interest thereon is recognised as
a finance cost in the statement of profit or loss and the carrying amount at
the year-end is a liability in the SFP.
 After initial recognition the equity amount will remain unchanged in the SFP until
the end of the instrument’s life.

Question 5

Financial instruments: 2.3 Servicing of finance

Answer 5

Finance costs unless all equity, then dividend

The service of finance includes:
 Interest
 Dividends
 Gains and losses on the disposal of financial instruments.
The presentation of these items in the financial statements is determined by the
presentation of the financial instrument that gives rise to them.
If the financial instrument is shown as a financial liability or asset, the servicing of
finance relating to that instrument is shown as a finance cost or interest income.
If the financial instrument is shown as equity, then the servicing of finance relating to
that instrument is shown as a dividend.
With convertible instruments, the servicing of finance is deemed to belong to the
financial liability component.

Question 6

Financial instruments: Financial liabilities

Answer 6

In FAR we assumed all financial assets and liabilities would be
accounted for in the same way, using amortised cost. In reality, this
is not the case and here we will look at the rules in more detail.
There are 2 categories of financial liability:
 Financial liabilities at fair value through profit or loss (FVPL)
Financial liabilities held for trading, acquired for the purpose of repurchasing in
the short term. This category includes all unfavourable derivatives.
It may also include the designation of any financial liability that would normally
be accounted for at amortised cost but has been designated to be accounted for
at FVPL to reduce or eliminate an accounting mismatch.
 Amortised cost
Financial liabilities that are not classified as FVPL.

Question 7

Financial instruments: Financial liabilities 3.1 Initial recognition

Answer 7

A financial liability should be recognised when the entity enters into the contractual
provisions.
The liability should initially be recognised at the fair value which takes into account
whether the instrument needs discounting to present value (for example, if it is
convertible debt).
The treatment of transaction costs such as brokers’/professional fees depends on the
classification of the liability:
 If a FVPL financial liability – then transaction costs are not included
as an adjustment to the initial fair value, but are instead expensed to
profit or loss.
 If an amortised cost financial liability – then deduct transaction costs
from the initial fair value.

Question 8

Financial instruments: 3.2 Subsequent treatment of financial liabilities

Answer 8

FVPL liabilities are revalued to fair value at the reporting date with gains and
losses taken to the SPL.
 Under the amortised cost approach, interest is accounted for over
the life of the liability using the effective rate of interest and taken
to the statement of profit or loss. The coupon interest is deducted
from the carrying amount as paid. The coupon rate is the cash
element of the interest, based on the nominal value of the
instrument.
 Note: If you are not provided with an effective rate, it can be calculated using
the RATE function in the exam software spreadsheet function. To calculate the
RATE, the following variables need to be input into the RATE function:
Nper = the number of periods
Pmt = the coupon payments in any single period
Pval = the present value of the asset (its initial value), inserted as a negative
number
Fval = the future value (the amount paid at maturity).
‘Type and guess’ can be left blank.

Question 9

Financial instruments: 3.3 Credit risk on financial liabilities classified as FVPL

Answer 9

If a company’s credit risk rating were to deteriorate, this would lead to a decline in the
fair value of the liability and hence create a gain.
IFRS 9 recognises that it would be anomalous to recognise a gain in the SPL when it
was caused by an adverse event such as the increase in credit risk.
Therefore, IFRS 9 requires that any element of the gain related to the deterioration in
credit risk is credited to OCI, not the SPL.

Question 10

Financial instruments: 3.4 Derecognition of financial liabilities

Answer 10

An entity shall remove a financial liability (or a part of a financial
liability) from its statement of financial position when, and only
when, it is extinguished – i.e. when the obligation specified in the
contract is discharged or cancelled or expires.’ (IFRS 9, para 3.3.1)
Any difference arising on derecognition is taken to profit or loss.

Question 11

Financial instruments: 3.4 Derecognition of financial liabilities 3.5 Exchange or modification of debt

Answer 11

If an existing loan is exchanged for a new loan with the existing lender, or if the terms
of an existing loan are changed, the accounting treatment will depend on whether the
new terms are deemed to be substantially different.
To be substantially different, the PV of the cash flows under the new arrangement,
including fees (all discounted at the original effective rate), must be at least 10% different to the PV of the remaining cash flows under the original arrangement.

Difference of 10% or more
The old liability is deemed to be extinguished, and a new liability is recognised in its
place:
 Derecognise the existing liability
 Recognise a new liability at its fair value
 The difference is recognised in the statement of profit or loss
 Any fees incurred are also recognised in the statement of profit or loss.

Difference of less than 10%
The original liability is deemed to have been modified:
 Do not derecognise the existing liability
 Restate the liability to the PV of the revised cash flows (discounted at the
original effective rate) and deduct any fees paid
 Any difference is taken to the statement of profit or loss.

Question 12

Financial instruments: Treasury shares

Answer 12

When companies reacquire their own shares, the consideration paid is
recorded directly in equity:
Dr Treasury shares
Cr Cash
If the company reissues the shares at a later date, the difference between the
carrying amount of the equity reserve and the cash received is recorded in equity:
Dr Cash
Cr Treasury shares
Dr or Cr Equity

Question 13

Financial instruments: Classification of financial assets per
IFRS 9 Financial Instruments 5.1 Categories of financial asset

Answer 13

Per IFRS 9 Financial Instruments, all financial assets should be classified as one of
the following categories:
 Financial assets at fair value through profit or loss (FVPL)
 Financial assets at fair value through other comprehensive income (FVOCI)
 Amortised cost.
Classification should be made when the instrument is first recognised. In certain rare
situations subsequent reclassification may be required.

Question 14

Financial instruments: Classification of financial assets per
IFRS 9 Financial Instruments 5.2 Classification: investments in equity instruments

Answer 14

FVPL
Default position

FVOCI
If not held for
short-term trading
and an irrevocable
designation is
made

Exception
IAS 27 allows a parent company, in its individual financial statements, to recognise
an investment in a subsidiary, associate, or joint venture at either cost, fair value in
accordance with IFRS 9, or using equity accounting.

Question 15

Financial instruments: Classification of financial assets per
IFRS 9 Financial Instruments 5.3 Classification: investments in debt

Answer 15

IFRS 9 specifies three ways of classifying financial assets that are debt instruments:
 Amortised cost
 Fair value through other comprehensive income
 Fair value through profit or loss.
Determining which category of financial asset to use requires consideration of two
tests. The financial asset is measured at amortised cost if it passes both:
 The business model test
The objective of the business model within which the asset is held is to hold the
asset to maturity to collect the contractual cash flows
and
 The contractual cash flow test
The contractual terms of the asset give rise to cash flows that are solely
repayments of principal and interest on the principal amount outstanding.
Note: By interest, IFRS 9 means consideration for the time value of money and
credit risk.

The financial asset is measured at fair value through other comprehensive
income if:
 The objective of the business model within which the asset is held is to both
collect contractual cash flows but also to increase returns when possible by
selling the asset
and
 The contractual terms of the asset give rise to cash flows that are solely
repayments of principal and interest on the principal amount outstanding.
If not classified as amortised cost or FVOCI, then the financial asset is measured at
fair value through profit or loss.

Question 16

Financial instruments: 5.4 Classification: Derivatives with gains

Answer 16

FVPL

Derivatives with gains are classified as fair value through profit or loss.

Question 17

Financial instruments: Accounting treatment of financial
assets per IFRS 9 Financial

Answer 17

When accounting for financial assets, the following issues need to be considered:
 Initial recognition
 Subsequent measurement
 Reclassification
 Impairments
 Derecognition.

Question 18

Financial instruments: Accounting treatment of financial
assets per IFRS 9 Financial 6.1 Initial recognition

Answer 18

A financial asset should be recognised when the entity enters into the contractual
provisions.
The asset should initially be recognised at the fair value, which takes into account:
 Whether the instrument needs discounting to present value (for
example, an interest-free loan, or a loan with interest below market
rates, given to build a business relationship. The present value is the
initial amount of the receivable. The difference between the proceeds
and present value is an expense in the statement of profit or loss.)
Note: in most cases discounting will not be necessary.
Transaction costs are not part of fair value, but should be taken into
account when acquiring a financial asset:
 If a FVPL asset – do not add transaction costs to the initial fair value,
but instead expense them to profit or loss.
 If any other financial asset – add transaction costs to the initial fair
value recognised.

Question 19

Financial instruments: Accounting treatment of financial
assets per IFRS 9 Financial 6.2 Subsequent measurement

Answer 19

The subsequent measurement of a financial instrument is determined by its
categorisation.
 FVPL and FVOCI assets are revalued to fair value at the reporting date.
 Other financial assets are held at amortised cost.

Question 20

Financial instruments: Accounting treatment of financial
assets per IFRS 9 Financial 6.3 Amortised cost accounting

Answer 20

 Under the amortised cost approach, the financial asset is initially
recorded at fair value with any transaction costs added. Interest is
accounted for over the life of the asset using the effective rate of
interest, and taken to the statement of profit or loss. The coupon
interest is deducted from the carrying amount as received. The
coupon rate is the cash element of the interest based on the
nominal value of the instrument.

Question 21

Financial instruments: Accounting treatment of financial
assets per IFRS 9 Financial 6.4 Fair value accounting

Answer 21

FVPL assets
 FVPL items are revalued to fair value at the reporting date and any gains or
losses on revaluation go to the statement of profit or loss.

FVOCI assets
 FVOCI assets are revalued to fair value at the reporting date and any gains or
losses on revaluation are shown as other comprehensive income and
accumulated in a separate reserve in equity.
 On disposal of an FVOCI asset, a gain or loss would be recognised based upon
the difference between disposal proceeds and carrying amount.
Note: Recognition of gain or loss on disposal
FVOCI investment in debt → Recognise gain/loss in SPL
FVOCI investment in equity → Recognise gain/loss in OCI/reserves
Note: If the asset is an investment in debt, we also reclassify any
balance that was previously recognised in reserves, to the SPL in the
year. We do not do this where the investment is in equity.
 Interest on an interest-bearing asset should be calculated using the effective
interest method and recognised in profit or loss.

Question 22

Financial instruments: 6.6 IFRS 13 Fair Value Measurement

Answer 22

IFRS 13 Fair Value Measurement defines fair value as ‘the price that
would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the
measurement date.’ (IFRS 13, para 9)
IFRS 13 Fair Value Measurement applies when another IFRS Standard requires or
permits fair value measurements. The requirements do not apply for share-based
payments under IFRS 2 Share-based payments, leases under IFRS16 Leases, NRV
for inventories in IAS 2 Inventories or value in use for IAS 36 Impairment of Assets.
IFRS 13 Fair Value Measurement seeks to increase consistency and
comparability in fair value measurement. A fair value hierarchy exists,
which identifies inputs used in valuation techniques to determine fair
value.

Question 23

Financial instruments: 6.6 IFRS 13 Fair Value Measurement

Fair value hierarchy

Answer 23

Fair value measurements are categorised based on the type of inputs to
the valuation techniques.
 Level 1 inputs – ‘quoted prices (unadjusted) in active markets
for identical assets or liabilities that the entity can access at
the measurement date.’ (IFRS 13, para 76)
 Level 2 inputs – ‘inputs other than quoted prices included
within Level 1 that are observable for the asset or liability,
either directly or indirectly.’ (IFRS 13, para 81)
E.g. quoted prices for similar assets/liabilities in active markets or
quoted prices for identical or similar assets or liabilities in markets
that are not active.
 Level 3 inputs – ‘unobservable inputs for the asset or liability.’
(IFRS 13, para 86), such as an income approach. These should
be kept to a minimum.
Income approach – ‘Valuation techniques that convert future
amounts (e.g. cash flows or income and expenses) to a single
current (i.e. discounted) amount. The fair value measurement is
determined on the basis of the value indicated by current market
expectations about those future amounts.’ (IFRS 13, Appendix A)

Question 24

Financial instruments: 6.6 IFRS 13 Fair Value Measurement Quoted price of an instrument in an active market (level 1)

Answer 24

When an active market exists, two prices will be quoted. They are the:
 Bid price – The price at which the dealer will buy (the lower price)
 Ask price – The price at which the dealer will sell (the higher price).
These should be accounted for as follows:
Bid price = fair value (i.e. how much the asset can be sold for).
Bid – ask spread (the difference between the bid and ask price) on acquisition =
transaction cost.
Note that IFRS 13 also permits the use of the mid-market price.

Question 25

Financial instruments: 6.6 IFRS 13 Fair Value Measurement Measurement of fair value

Answer 25

Fair value is based on the assumptions of the marketplace and is not
entity specific. Fair values include the condition and location of the asset
and any restrictions on its sale or use.
‘A fair value measurement assumes that the transaction to sell the
asset or transfer the liability takes place either:
(a) in the principal market for the asset or liability, or
(b) in the absence of a principal market, in the most
advantageous market for the asset or liability.’ (IFRS 13,
para 16)
The principal market is that with the greatest volume of activity that the entity can
access, and the most advantageous is the one that maximises the amount that would
be received for the asset or paid to extinguish the liability, after transport and
transaction costs.
Although transaction costs are taken into account when identifying the most
advantageous market they are ignored when determining fair value as transaction
costs are a characteristic of the transaction, not the asset or liability.

Question 26

Financial instruments: 6.6 IFRS 13 Fair Value Measurement Disclosures

Answer 26

The guidance includes enhanced disclosure requirement’s including:
 Information about the hierarchy level into which fair value measurements fall
 Transfers between levels 1 and 2
 For fair value measurements using level 3 inputs, the effect of the
measurements on profit or loss or other comprehensive income for the period.

Question 27

Financial instruments: 6.6 IFRS 13 Fair Value Measurement 6.7 Reclassification of financial assets

Answer 27

IFRS 9 requires that when an entity changes its business model for
managing financial assets, it should reclassify all affected financial
assets.
A change in business model only occurs when an entity begins or ceases to perform
an activity that is significant to its operations. This is expected to be a rare event.
The reclassification is applied prospectively from the reclassification date.
However, if a financial asset is classified at amortised cost, it does not mean that the
entity can never sell the asset. Infrequent or insignificant sales are permitted,
provided the business model to collect contractual cash flows remains unchanged.

Question 28

Financial instruments: 6.6 IFRS 13 Fair Value Measurement 6.7 Reclassification of financial assets

From Amortised
cost

To FVOCI

Answer 28

 Asset revalued to fair value, gain/loss taken to OCI
 Effective interest rate unchanged

Question 29

Financial instruments: 6.6 IFRS 13 Fair Value Measurement 6.7 Reclassification of financial assets

From Amortised
cost

To FVPL

Answer 29

Asset revalued to fair value, gain/loss taken to
SPL

Question 30

Financial instruments: 6.6 IFRS 13 Fair Value Measurement 6.7 Reclassification of financial assets

From FVOCI

To Amortised
cost

Answer 30

 Fair value at reclassification date is the new
gross carrying amount
 Cumulative gains/losses reversed out of OCI
against carrying amount of asset (as if the
asset had always been held at amortised cost)
 Effective interest rate unchanged

Question 31

Financial instruments: 6.6 IFRS 13 Fair Value Measurement 6.7 Reclassification of financial assets

From FVOCI

To FVPL

Answer 31

Continue to measure at fair value
 Cumulative gains/losses in OCI recycled to
SPL

Question 32

Financial instruments: 6.6 IFRS 13 Fair Value Measurement 6.7 Reclassification of financial assets

From FVPL

To Amortised
cost

Answer 32

Fair value at reclassification date is the new
gross carrying amount
 Effective interest rate calculated based on fair
value at reclassification

Question 33

Financial instruments: 6.6 IFRS 13 Fair Value Measurement 6.7 Reclassification of financial assets

From FVPL

To FVOCI

Answer 33

 Continue to measure at fair value
 Effective interest rate calculated based on fair
value at reclassification

Question 34

Financial instruments: 6.8 Impairments of financial assets (credit losses)

Answer 34

Scope of IFRS 9 impairment rules
The following instruments are in the scope of the IFRS 9 impairment requirements:
 Financial assets that are debt instruments measured at amortised cost or fair
value through other comprehensive income (FVOCI).
IFRS 9 impairment rules do not apply to:
 Financial assets classified as FVPL (since any fair value
movements are already reflected in profit or loss).
 Equity instruments designated as FVOCI on initial recognition
(since gains and losses are never recycled to profit or loss).
Key definitions
 Credit loss: the difference between the present value of the
contractual cash flows that are due to an entity and the present
value of the cash flows that the entity actually expects to receive,
both discounted at the original effective interest rate of the
instrument.
Note: since this calculation considers both the amount and the timing of payments, a
credit loss arises even if the entity expects to be paid in full but later than when
contractually due.
 Expected credit losses (ECL): a probability-weighted estimate of credit losses.
 Lifetime expected credit losses (LEL): the expected credit losses over the
remaining life of a financial asset.
 12-month expected credit losses: the proportion of lifetime expected credit
losses that result from default events that are possible within 12 months of the
reporting date.

Question 35

Financial instruments: Impairment accounting under IFRS 9

Answer 35

1. Start with 12 expected credit loss allowance
2. If credit worsens (30d or evidence), lifetime expected losses

Initial treatment:
For financial assets within the scope of the impairment rules, entities must create a
loss allowance upon initial recognition of the asset. This allowance is based on the
expected loss as a result of default.
On initial recognition, this loss allowance will be equal to 12-month expected credit
losses.

Subsequent treatment:
The loss allowance will subsequently need to be adjusted depending on whether the
credit quality of the financial asset has significantly deteriorated since its initial
recognition.
For this purpose, the impairment model of IFRS 9 classifies financial assets into
three stages as follows:
Stage Description Loss allowance equal to
Stage 1 Financial assets whose credit quality
has not significantly deteriorated since
initial recognition.
12-month expected credit
losses
Stage 2 Financial assets whose credit quality
has significantly deteriorated since
their initial recognition (rebuttable
presumption if > 30 days past due).
Lifetime expected credit
losses (LEL)
Stage 3 Financial assets for which there is
objective evidence of impairment
(credit impaired) at the reporting date
(see below).
Lifetime expected credit
losses (LEL)

Question 36

Financial instruments: Stage 3 Objective evidence of impairment (credit impaired)

Answer 36

The following are indications that a financial asset or group of assets may be
impaired (IFRS 9: Appendix A).
(a) Significant financial difficulty of the issuer
(b) A breach of contract, such as a default in interest or principal payments
(c) The lender granting a concession to the borrower that the lender would not
otherwise consider, for reasons relating to the borrower’s financial difficulty
(d) It becomes probable that the borrower will enter bankruptcy
(e) The disappearance of an active market for that financial asset because of
financial difficulties
(f) The purchase or origination of a financial asset at a deep discount that reflects
the incurred credit losses.
It is not always possible to single out one particular event; rather, several events may
combine to cause an asset to become credit-impaired.

Question 37

Financial instruments: Calculation of interest income

Answer 37

Interest income for financial assets at stage 1 or 2 of the IFRS 9 impairment model is
calculated on the gross carrying amount of the financial asset.
However, for financial assets at stage 3, interest income is calculated based on the
net carrying amount (after deducting the credit impairment allowance from the gross
carrying amount).

Question 38

Financial instruments: Accounting for financial assets that are debt instruments measured at
amortised cost

Answer 38

 Impairment losses are taken to the statement of profit or loss.

Question 39

Financial instruments: Accounting for financial assets that are debt instruments measured at FVOCI

Answer 39

Debt instruments classified as FVOCI are also subject to the ‘expected loss’
impairment model of IFRS 9, with increases or decreases in the allowance
recognised in profit or loss.
However, since a FVOCI financial asset is already carried at fair value, the loss
allowance is not netted off against the value of the asset on the face of the
statement of financial position.
If the financial asset is measured at FVOCI then the entry to record an
increase in the allowance is:
Dr SPL X
Cr OCI X
This transfers part of the fall in fair value relating to expected credit
losses from OCI to profit or loss.

Question 40

Financial instruments: Simplified approach for trade receivables

Answer 40

 For trade receivables that do not have an IFRS 15 financing element (i.e. they
have not been discounted to PV because the cash flow is < 12 months from the
initial sale), the loss allowance is measured at the lifetime expected credit
losses, from initial recognition.
For other trade receivables, the entity can choose to apply the three-stage
approach or to recognise an allowance for lifetime expected credit losses from
initial recognition.

Question 41

Financial instruments: Simplified approach for trade receivables 6.9 Derecognition

Answer 41

A financial asset should be derecognised when:
 The entity transfers substantially all the risks and rewards of ownership to
another party, or
 The contractual rights to the cash flows have expired.
This applies to the whole, or part of, a financial asset. Any gains or losses on
derecognition are recognised in the profit or loss or OCI, depending on classification.
Common derecognition issues include:
 Repurchase agreements
A repurchase agreement is when a company sells an asset and simultaneously
enters into a contract to repurchase the asset at a fixed future date. The details
of the agreement need to be examined to determine whether the company has
significantly transferred the risks and rewards of ownership of the asset.
 Factoring/invoice discounting
A factor gives the company cash in exchange for the rights to the future receipts
from the company’s receivables.
If the factoring/invoice discounting arrangement is without recourse, then the
company does not have to compensate the factor for non-payment or late
payment by the receivables and has therefore passed on the risks of ownership
of the asset.
If the factoring/invoice discounting arrangement is with recourse, then the
company guarantees the future performance of the receivables and will
compensate the factor if they are slow to pay or do not pay. In this case, the
facts must be examined to determine whether substantially all the risks of
ownership have been transferred.

Question 42

Financial instruments: Derivatives and embedded derivatives 7.1 Derivatives

Answer 42

According to IFRS 9 Financial Instruments, a derivative is a financial instrument:
 Whose value is derived from the value of an underlying item. As
the value of the underlying item changes, the value of the
derivative changes in response.
 Which requires no, or a small, initial investment.
 Which is settled at a future date.
Examples of underlying items include:
 Interest rates
 Currency rates
 Commodity prices
 Equity prices.
Examples of derivatives include:
 Forward contracts
 Futures
 Swaps
 Options
 Warrants.
Note: A contract to buy or sell a non-financial asset (e.g. a commodity) is a
derivative if:  It can be settled in cash or by exchanging another financial instrument.
 The contract was not entered into for the purpose that the non-financial item
would be delivered to the entity to be used within the entity’s business.

Question 43

Financial instruments: Derivatives and embedded derivatives 7.2 Embedded derivatives

Answer 43

7.2 Embedded derivatives
Sometimes, a contract that isn’t a derivative (e.g. a bond) can have a
derivative contract included in it (e.g. an option to convert the bond into
a fixed number of ordinary shares at a future date).
 The non-derivative contract is called a ‘host’ contract.
 The derivative included therein is called an ‘embedded derivative’.

7.3 Accounting for an embedded derivative

If the host contract is a financial asset, we do not separate the
embedded derivative. Instead the entire contract is classified as FVPL.

If the host contract is not a financial asset (e.g. the host contract is a financial liability
or a lease), then in the following circumstances, we must separate out the embedded
derivative:
1. The combined contract is not FVPL (as it would be pointless to separate out a
derivative)
2. A separate instrument with the same characteristics would meet the definition of
a derivative
3. The characteristics and the risks of the embedded derivative are not closely
related to the host contract.

Question 44

Financial instruments: Derivatives and embedded derivatives 7.2 Embedded derivatives 7.4 ‘Closely related’

Answer 44

IFRS 9 does not define ‘closely related’. This means that any given
instrument must be analysed in detail, and points of contention can
arise.
In general, an embedded derivative is considered to be closely related if it modifies
the inherent risk of the combined contract but leaves the instrument substantially
unaltered.
Examples of embedded derivatives which would be considered closely
related and therefore, do not require splitting out can be found in IFRS
9 para. B4.3.8
Examples of embedded derivatives which would not be considered
closely related and therefore, do require splitting out can be found in
the IFRS book: IFRS 9 para. B4.3.5

Question 45

Financial instruments: Financial instruments: disclosures

Answer 45

The disclosure requirements of IFRS 7 Financial Instruments: Disclosures are
intended to give information about the significance of financial instruments and the
nature and extent of risks arising from financial instruments.
In questions involving the audit of financial instruments, it is very
common to see reference to confirmation of the IFRS 7 disclosures as a
relevant audit procedure in the marking guide.
8.1 Disclosure on the statement of financial position or within the notes
The carrying amount of all of the following should be disclosed separately, either on
the face of the statement of financial position or within the notes:
 Financial assets held as FVPL
 Financial assets held as FVOCI
 Financial assets held as amortised cost
 Financial liabilities held as FVPL
 Other financial liabilities.
8.2 Qualitative and quantitative disclosures
Qualitative disclosures are discursive disclosures covering an entity’s exposure to
risk and how the risks arise, along with the objectives, policies and procedures for
managing the risk.
Quantitative disclosures are numerical disclosures giving information on the
exposure to risk at the reporting date and the concentration of risk. The information
disclosed should be consistent with internal management information.

Question 46

Financial instruments: 8.3 Types of risk

Answer 46

The qualitative and quantitative disclosures are required for the following types of
risk:
 Market risk – the risk that the fair value of future cash flows will fluctuate due to
changes in market prices.
 Credit risk – the risk that one party will cause financial loss to another party by
failing to discharge its obligations.
 Liquidity risk – the risk that the entity cannot meet its financial obligations when
they fall due.

Question 47

Financial instruments: Audit and assurance implications of
financial instruments: Tests/procedures

Risks

Inherently complex and could lead
to a lack of management
understanding

Answer 47

Confirm audit team have adequate
experience and skill with IFRS 9
Financial Instruments
 Increase the level of review of audit
work
 Understand the factors which affect the
entity’s derivative activities (including
the general economy, industry and
entity)
 Assess the risks associated with these
transactions as part of the risk
procedures of the audit and ensure
there is a strong control environment in
place at the entity
 Perform a test of controls in this area

Question 48

Financial instruments: Audit and assurance implications of
financial instruments: Tests/procedures

Risks

FV could be hard to determine

Answer 48

Check original fair value to sales
contract/bank statement
 If the market value is used, check the
market value to supporting
documentation
 Review post year-end events to
confirm year-end valuation
 If a model is used to calculate FV –
audit the applied model. For example,
check the model is appropriate, review
inputs, recalculate

Question 49

Financial instruments: Audit and assurance implications of
financial instruments: Tests/procedures

Risks

Incorrect classification of financial
instruments

Answer 49

Compare to industry norms
 Compare to similar transactions
previously carried out by the entity
 Check appropriate documentation is in
place to ensure classification occurred
on initial recognition and not in
hindsight

Question 50

Financial instruments: Audit and assurance implications of
financial instruments: Tests/procedures

Risks

Incorrect accounting treatment

Answer 50

Review entity’s working papers and
recalculate
 Ascertain how the effective interest
rate has been determined and confirm
it is appropriate
 Check movements on instruments
have been charged to the correct place
in the accounts.

Question 51

Financial instruments: Audit and assurance implications of
financial instruments: Tests/procedures

Risks

Incorrect disclosures

Answer 51

 Ensure disclosure complies with IFRS
7 Financial Instruments: Disclosures