Chapter 14

Accounting for financial

instruments

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Deegan, Financial Accounting, 8e 14-1
Objectives of this lecture
• Understand what a financial instrument is
• Understand the factors that determine whether a financial
instrument shall be presented as debt or equity
• Understand the measurement rules for financial instruments
• Know how to account for gains and losses on financial
instruments
• Understand how to account for derivatives and the assets and
liabilities that are part of a hedging arrangement

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Deegan, Financial Accounting, 8e 14-2
Relevant accounting standards
There are three standards that are of direct
importance to this lecture, these being:
1. AASB 7 Financial Instruments: Disclosure
2. AASB 132 Financial Instruments: Presentation
3. AASB 9 Financial Instruments

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Deegan, Financial Accounting, 8e 14-3
Financial instruments defined
• A financial instrument (AASB 132) is:
– any contract that gives rise to both a financial asset of
one entity and a financial liability or equity instrument
of another entity
• A financial asset (AASB 132) would include:
– cash, or
– a contractual right to receive cash or another financial
asset from another entity, or
– a contractual right to exchange financial instruments
with another entity under conditions that are potentially
favourable, or
– an equity instrument of another entity

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Deegan, Financial Accounting, 8e 14-4
Financial instruments defined (cont.)
• A financial liability (AASB 132) would include:
– any liability that is a contractual obligation
 to deliver cash or another financial asset to another entity; or
 to exchange financial assets or liabilities with another entity
under conditions that are potentially unfavourable; or
– a contract that will or may be settled in the entity’s own equity
instruments and
 is 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
• An equity instrument (AASB 132) is:
– any contract that evidences a residual interest in the assets of
another entity after deduction of all its liabilities

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Deegan, Financial Accounting, 8e 14-5
Financial instruments defined (cont.)

• Central to the definition of a liability is whether or not a

‘contractual obligation’ exists
– If there is no contractual obligation to deliver cash or
another financial asset, or to exchange another financial
instrument under conditions that are potentially
unfavourable, it is considered to be an equity instrument
– What does ‘unfavourable’ mean in this context? See
Worked Example 14.1, which shows how the issue of
share options creates a financial asset in the accounts of
the holder of the options, and a financial liability in the
accounts of the issuer
– In the context of the issue of options, the likelihood of the
option being exercised does not impact on its classification
as a financial liability

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Deegan, Financial Accounting, 8e 14-6
Financial instruments defined (cont.)
• Examples of financial instruments
– cash at bank
– bank overdrafts
– term deposits
– trade receivables and payables
– investments
– options
– forward foreign exchange agreements
– foreign currency swaps

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Deegan, Financial Accounting, 8e 14-7
Financial instruments defined (cont.)
• Primary financial instruments:
– include receivables, payables and equity securities
such as ordinary shares—accounting treatment fairly
straightforward
• Derivative financial instruments:
– create rights and obligations with the effect of
transferring one or more of the financial risks inherent
in an underlying primary financial instrument
– include financial options, futures, forward contracts
and interest rate and currency swaps
• Refer to Worked Example 14.2—Derivative financial
instrument
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Deegan, Financial Accounting, 8e 14-8
Debt versus equity components of financial
instruments
• The issuer of a financial instrument must determine whether to
disclose it as a liability or equity (AASB 132)
– required to consider economic substance rather than just
the legal form
• Critical feature in differentiating financial liability from equity is
the existence of a contractual obligation on the part of one
entity either to deliver cash or another financial asset, or to
exchange another financial instrument
• If classified as debt, then periodic payments are classified as
interest expenses, which will affect profits. If classified as
equity, then the payments are dividends and will not impact
reported profits
– Where an instrument is classified as debt (a liability) the related
interest can sometimes be treated as part of the cost of an asset
under construction
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Deegan, Financial Accounting, 8e 14-9
Measurement of financial instruments

• According to AASB 9:
– Financial instruments are initially to be measured at fair
value
– How they are subsequently measured, and how any gain or
loss is treated, is then dependent upon how the financial asset
is classified
• Categories of financial instruments
Depending upon the entity’s business model for managing its
financial assets and the contractual cash flows of the financial
asset, financial assets shall subsequently be measured at either:
– Amortised cost
– Fair value through other comprehensive income
– Fair value through profit or loss

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Deegan, Financial Accounting, 8e 14-10
Measurement of financial assets at
amortised cost

• According to AASB 9, a financial asset shall be subsequently

measured at ‘amortised cost’ if both of the following conditions or
‘tests’ are met:
– The asset is held within a business model whose
objective is to hold assets in order to collect contractual
cash flows (referred to as the business model test); and
– The contractual terms of the financial asset give rise on
specified dates to cash flows that are solely payments of
principal and interest on the principal amount
outstanding (the cash flow characteristics test).
• Given the reference to cash flows associated with interest and
principal, we can see that the option to use amortised cost is
available for debt instruments (bond, debenture) rather than
equity instruments.

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Deegan, Financial Accounting, 8e 14-11
Worked Example 14.5—Determining the amortised cost
of a financial asset

On 1 July 2018, Jack Ltd (A)acquired some corporate bonds issued by

McCoy Ltd. (B)
These bonds cost $1 066 242. (A paid to B) –Fair value. They had a
‘face value’ of $1 million and offered a coupon rate of 10 per cent paid
annually ($100 000 per year, paid on 30 June). The bonds would
repay the principal of $1 million on 30 June 2022.
At the time the market only required a rate of return on 8 per cent on
such bonds.
Jack Ltd operates within a business model where government bonds
are held in order to collect contractual cash flows and there is no
intention to trade them.
Assume that there were no direct costs associated with acquiring the
bonds.

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Deegan, Financial Accounting, 8e 14-12
Worked Example 14.5—Determining the amortised cost
of a financial asset (cont.)

REQUIRED
(a) Explain why the company was prepared to pay $1 066 242 for
the bonds given that, apart from the interest, they expect to receive
only $1 million back in four years.
(b) Determine whether Jack Ltd can measure the government
bonds at amortised cost.
(c) Calculate the amortised cost of the bonds as at 30 June 2019,
2020, 2021 and 2022.
(d) Provide the accounting journal entries for the years ending
30 June 2019 and 2020.

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Deegan, Financial Accounting, 8e 14-13
Worked Example 14.5—Determining the amortised cost
of a financial asset (cont.)

(a) In this instance the market was requiring an 8 per cent return on
securities such as these. However, McCoy Ltd was offering a 10 per
cent return. In this case, and using present values, the issue price will
be $1 066 242, (because the market rate is higher) determined as
follows:

Present value of interest stream of four payments of $100 000

per year at the end of the next 4 years:
$100 000 × 3.312 126 4 = $331 213
Present value of the principal to be received in 4 years:
$1 000 000 × 0.735 029 7 = $735 029
Fair value at 1 July 2018 $1 066 242

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Deegan, Financial Accounting, 8e 14-14
Worked Example 14.5—Determining the amortised cost
of a financial asset (cont.)

(b) Jack Ltd can use amortised cost as the basis for measuring
government bonds as:
• The government bonds are held within a business model whose
objective is to hold them in order to collect contractual cash
flows, and
• The contractual terms of the government bonds give rise on
specified dates to cash flows that are solely payments of
principal and interest on the principal amount outstanding.

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Deegan, Financial Accounting, 8e 14-15
 Worked Example 14.5—Determining the amortised cost
of a financial asset (cont.)
(c) Date Opening Interest Principal Closing
present revenue repayment present
value value
1 July 2018 1 066 242
30 June 2019 1 066 242 85 299 14 701 1 051 541
30 June 2020 1 051 541 84 123 15 877 1 035 664
30 June 2021 1 035 664 82 853 17 147 1 018 517
30 June 2022 1 018 517 81 483 1 018 517 0

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Deegan, Financial Accounting, 8e 14-16
Worked Example 14.5—Determining the amortised cost
of a financial asset (cont.)

(d) 1 July 2018

Dr Investment in corporate bonds 1 066 242
Cr Cash 1 066 242
30 June 2019
Dr Cash 100 000
Cr Investment in corporate bonds 14 701
Cr Interest income 85 299
30 June 2020
Dr Cash 100 000
Cr Investment in corporate bonds 15 877
Cr Interest income 84 123

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Deegan, Financial Accounting, 8e 14-17
Financial asset measured at fair value
through profit or loss
• All financial assets can be measured at fair
value through profit or loss if the entity has made
an election to do so (on the basis that it will
eliminate or significantly reduce a measurement
or recognition inconsistency)
• All equity investments shall subsequently be
measured at fair value. The change in fair value
shall:
– go to profit or loss if the equity investment is held
primarily for trading
– go to OCI if the entity has elected to present changes
in fair value through OCI
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Deegan, Financial Accounting, 8e 14-18
Worked Example 14.6—Accounting for a financial
asset at fair value through profit or loss

On 1 July 2018, Bear Ltd acquired 100 000 shares in Island Ltd at
a price of $10 each. There were brokerage fees of $1500. The
closing market price of Island Ltd shares on 30 June 2019—which
is the entity’s financial year end—was $12. Bear Ltd has not made
the election to account for its equity investments at fair value
through OCI.
REQUIRED
Provide the required accounting journal entries for Bear Ltd to
account for the investment in Island Ltd using fair value through
profit or loss.

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Deegan, Financial Accounting, 8e 14-19
Worked Example 14.6—Solution

1 July 2018
The financial asset would initially be recorded at fair value. If
the financial asset is measured at fair value through profit or
loss then transaction costs associated with the acquisition of
the asset shall be treated as an expense within profit or loss.
Dr Investment in Island Ltd 1 000 000
Dr Brokerage fee expense 1 500
Cr Cash 1 001 500

30 June 2019
Dr Investment in Island Ltd 200 000
Cr Gain in fair value of equity investments (profit or loss) 200 000

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Deegan, Financial Accounting, 8e 14-20
 Measurement of financial assets at fair
value through other comprehensive income
For debt instruments:
• A reporting entity can make an election to measure debt
instruments at fair value through other comprehensive income
(meaning the gains or losses on the financial asset do not go
directly to profit or loss) if both of the following conditions are met:
– the financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling
financial assets, and
– the contractual terms of the financial asset give rise on specified
dates to cash flows that are solely payments of principal and interest
on the principal amount outstanding.
For equity instruments:
• If they are not held for trading, then the reporting entity can make
an election to measure the equity instruments at fair value through
OCI

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Deegan, Financial Accounting, 8e 14-21
Measurement of financial assets at fair value through
other comprehensive income (cont.)

For debt instruments measured at fair value through OCI:

– changes in fair value will be included within OCI
– interest revenue, expected credit losses and foreign exchange
gains and losses are included within profit or loss
– when the asset is derecognised (sold) the cumulative gain or loss
recognised within OCI is reclassified from equity to profit or loss

For equity instruments measured at fair value through OCI:

– changes in fair value will be included within OCI
– dividends received from the equity instruments will be included
within profit or loss, and
– changes in fair value of equity instruments that are included within
OCI shall not be reclassified to profit or loss on the occurrence of
an event such as the sale of the investments

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Deegan, Financial Accounting, 8e 14-22
Worked Example 14.7—Accounting for a financial asset
at fair value through other comprehensive income

The facts are the same as those in Worked Example 14.6 except
this time Bear Ltd has made the decision to measure the equity
investment at fair value through other comprehensive income.

REQUIRED
Provide the required accounting journal entries for Bear Ltd to
account for the investment in Island Ltd using fair value through
other comprehensive income.

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Deegan, Financial Accounting, 8e 14-23
Worked Example 14.7—Solution
1 July 2018
The financial asset would initially be recorded at fair value. If the
financial asset is measured at fair value through other
comprehensive income then transaction costs associated with the
acquisition of the asset shall be included as part of the cost of the
asset.
Dr Investment in Island Ltd 1 001 500
Cr Cash 1 001 500

30 June 2019
Dr Investment in Island Ltd 200 000
Cr Gain in fair value included within OCI 200 000
There would be a reserve that is part of equity, which would
accumulate the gains that are included within OCI. For equity
instruments, this reserve cannot subsequently be transferred to
profit or loss.
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Deegan, Financial Accounting, 8e 14-24
Recognition and measurement of financial
liabilities
• Initially to be measured at fair value
• Most financial liabilities will then—in the
period after initial recognition—be
measured at amortised cost
• However, some financial liabilities shall
be measured at fair value through profit
or loss, for example, some derivatives

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Deegan, Financial Accounting, 8e 14-25
 Worked Example 14.11—Financial liabilities other
than those measured at fair value
On 1 July 2018, Slater Ltd issued four-year bonds with a total face
value of $100 000 and a coupon interest rate of 10 per cent per
annum, payable annually in arrears. The market interest rate for
Slater’s bonds was 12 per cent and so the company had to
discount the issue price to its fair value of $93 923.
Amortised
Increase in cost of bond
Beginning Interest at bond payable payable
bond Interest 12% (column (column 4 – (column 2 +
payable payment 2 × 12%) column 3) column 5)
Year ended ($) ($) ($) ($) ($)
06/19 93 923 10 000 11 272 1 272 95 195
06/20 95 195 10 000 11 423 1 423 96 618
06/21 96 618 10 000 11 594 1 594 98 212
06/22 98 212 10 000 11 788 1 788 100 000

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Deegan, Financial Accounting, 8e 14-26
Worked Example 14.11—Financial liabilities other than
those measured at fair value (cont.)
1 July 2018
Dr Cash 93 293
Cr Bond payable 93 293
(issue of bonds for $93 293—financial instruments shall initially be
measured at fair value)

30 June 2019
Dr Interest expense 11 272
Cr Bond payable 1 272
Cr Bank 10 000
(interest payment and amortisation of bond payable using effective
interest rate of 12 per cent)

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Deegan, Financial Accounting, 8e 14-27