AcF 311 Financial instruments (Workshop F 2022)
At the end of this workshop, you should be able to account for different types of complex
financial instruments
Question 1: Classification of financial instruments
C plc has entered into the following transactions during the year to 31 December 2019.
Required:
For each of the above transactions,
•
•
•
Identify whether the transaction results in a financial asset, liability, equity
instrument or derivative and explain your reasoning.
Determine the category for subsequent measurement according to IFRS 9.
Explain your reasoning.
Explain the correct financial reporting treatment under IFRS 9 setting out clearly
where subsequent measurement of gains or losses are recorded ? Ignore the
impairment of financial assets.
a) Bought 6,000 shares in P Ltd at £2 per share. The shareholding represents 10%
of the share capital of P Ltd
This is a financial asset - and is an equity investment .
A 10% investment would not give significant control so this is not an investment accounted for
as either a subsidiary or an associate.
However, in the parent company financial statements, the parent company would account for
this in any case under IFRS 9 (there is an option under certain circumstances to use historical
cost).
Under IFRS 9 equity investments by default are classified as fair value with gains or losses
being taken to profit or loss.
C Plc could make an irrevocable election to classify this as at fair value through OCI. In which
case, the investment will be held at fair value and movements in the fair value are taken to
other comprehensive income and will not affect profit reported in the year
Initial recognition
Debit Investment
Credit cash
£12,000
£12,000
At the year end remeasure to fair value – without election default adjustment is:
Dr/Cr Profit or loss
Dr/Cr investment
1
Being increase/ decrease in fair value.
With election – the movement is taken to OCI
b) Bought a £1 million 6% debenture from T plc. Interest is payable yearly at 6% the debentures were acquired at par and are redeemable in 2024. C plc intends
to collect interest and to receive the debenture repaid in 2024 (i.e. the principal
repaid). C Plc does not intend to sell the debenture before redemption.
The investment in debentures is a financial asset under IFRS 9. A receivable could be
measured at either amortised cost of fair value with gains or losses to profit or loss depending
on the business model of C plc – as the business model does not include the intention to sell
before maturity then it should be measured at amortised cost which as the investment is at par
£1 million with interest being credited to profit or loss.
c) Borrowed £2 million from a financial entity using its freehold office building as
security. The loan is repayable in 5 years’ time an interest rate of 5% is charged.
C has entered into a mortgage ie a loan, which is a financial liability.
The contractual obligation to repay £2m is a financial liability. The appropriate accounting
treatment is to record the transactions as a liability. This is not a derivative nor a
compound instrument and is therefore categorized as an ‘other financial liability’. Any
changes in the fair value of the loan would be taken to profit and loss. Interest charged is
taken to the profit or loss. Disclosure would be required of the security given in the form of
the charge over freehold property. The liability will be shown as non current liability.
d) Entered into a foreign exchange contract on 1 January 2020 to sell $400,000 in
six months for £250,000. At the yearend 31 March 2020, the value of the contract
has increased, a similar contract would be worth £260,000. The contract is not a
hedge transaction.
The contract is in the money – i.e. it would cost more at the year end to buy a similar contract.
Therefore, this is a derivative contract – and therefore a financial asset .
Normal treatment of a derivative contract is to recognise the increase in fair value to profit or
loss:
Debit Financial asset £10,000
Credit profit or loss £10,000
2
Question 2: Amortised cost
Razak plc purchased a 6% bond in Imposter plc on 1 October 20X5 (the issue date) at par for
£1.2 million. The interest is payable annually in arrears. The bond is redeemable on 30
September 20X7 for £1.575 million. Razak plc intends to hold the bond until maturity and to
collect the contractual cash flows. The bond has an effective interest rate of 15%.
Required:
a) Explain whether the bond is financial asset, liability, equity instrument or derivative
from the perspective of Razak plc.
b) Determine the category for subsequent measurement of the bond according to IFRS 9.
c) Provide journal entries for initial recognition and subsequent measurement of the bond
for the accounting periods 20X5, 20X6 and 20X7. Razak plc’s accounting period ends
on 30 September.
a) The bond is a loan to another company and as it has a fixed maturity date it should be
classified as a receivable – financial asset and held at amortised cost because the
business model is to collect cash flows (i.e. the interest)
b) The bond is subsequently measured at amortised cost at the end of 30 September the original cost less the interest received from Imposter but grown by the effective
interest which is the amount of interest credited to the income statement. The purpose
of showing the debt at amortised cost is to show the debt growing over the term of the
loan to its maturity value of £1.575 m in 20X
£’000
Year 1
Year 2
Year 3
1200
1308
1432.2
Interest to
income
statement at
15%
£’000
180
196.2
214.8
Cash interest received at
6%
£000
£000
(72)
(72)
(72)
1308
1432.2
1575
Accounting entries therefore are as follows:
Debit Loan to Imposter
Credit Cash
£1,200,000
£1,200,000
Debit Cash – interest received
Credit Loan to Imposter
£72,000
£72,000
Debit Loan to Imposter
Credit Income statement -Interest receivable
£180,000
£180,000
3
Question 3 Amortised cost and effective interest rate
On 1 January 20X1, Mendip Ltd borrowed £10 million from a bank on the following terms:



Arrangement fees of £20,000.
Interest payable at 3% for the first three years and then at 4% for the remainder of the
loan.
The loan will be repaid in full after 5 years (on 31 December 20X6).
Required
1) Calculate the interest charge to be included in the statement of profit or loss for each of
the five years of the loan.
2) Mendip decided to repay the loan after four years, on 31 December 20X5. Explain the
financial reporting implications of this decision.
Calculation of effective interest rate
Use the IRR function on a spreadsheet or calculate.
The cash flows are
£000
10,000
At inception
Less: arrangement
fee
20
9,980
Interest
Years 1 - 3
3%
Years 4-5
4%
Effective interest rate
-300
-300
-300
-400
-400
10,400
3.51%
Apply interest rate to the loan and accrue interest cost
3.51% Cash interest
4
9,980
350
-300
10,030
10,030
352
-300
10,082
10,082
354
-300
10,136
10,136
356
-400
10,092
10,092
354
-400
10,046
46 roundings
Journals
Jnl 1
Debit Loan
Debit cash
Credit Loan
Being loan received
Jnl2
Debit Loan
Credit cash
Being interest payment
£000
20
9,980
10,000
300
300
Jnl 3
Debit finance costs
350
Credit loan
350
Being adjustment for interest at the effective rate to reflect amortised cost
Repay after year 4 – difference is taken to profit or loss
9,980
10,030
10,083
10,137
Debit Loan
Debit cash
3.51% Cash interest
350
-300
10,030
352
-300
10,083
354
-300
10,137
356
-400
10,093
(10,000)
£000
10,000
10,000
5
Being loan repaid
Debit loan
Credit Profit or loss
Being loan written off to profit or loss
93
93
Question 4 Hedge accounting
On 1 November 20X5 an entity, whose functional currency is the pound (£), entered into a
contract to sell goods on 30 April 20X6 for $300,000 – this is a firm commitment to exchange
goods.
In fixing this dollar ($) price it worked on the basis of the spot exchange rate of $1.50 = £1, so
that revenue would be £200,000. To ensure it received £200,000, on 30 April 20X6 the entity
took out a six-month future to sell $300,000 for £200,000.
On 31 December 20X5 (which is the company's reporting date) an equivalent futures contract
traded at a value of £18,182. This may be taken as an acceptable approximation to fair value.
The future was therefore worth £18,182.
On 30 April 20X6, the spot exchange rate was $1.75 = £1 and the future was worth £28,571
(£200,000 – £($300,000/1.75 =) £171,429). The entity closed out its future position at the then
spot price and sold the goods.
Required
a) Explain whether this is a cashflow or fair value hedge.
Accounting policy choice
This is a contract of a highly forecast probably transaction and therefore would suggest that
this is a cashflow hedge.
However, there is an accounting policy choice for foreign currency under IFRS 9 – and this
could also be treated as a fair value hedge.
b) Set out and explain the appropriate financial reporting treatment for the hedge and
show the accounting entries using journals
Assuming cash flow hedge:
At 31.12.20X5, the future was therefore worth £18,182 and the entity recognised that amount
as a financial asset and as a profit in other comprehensive income – cash flow hedge
reserve.
Write out the journal entry to record the contract at the year end.
6
£000
Debit
Financial asset
18,182
Credit OCI – reserves
18,182
(Without hedge accounting this gain should go to profit or loss)
1. The futures contract at 30 April 20X6 is worth more because of the fall in the value of
the dollar
£
value at 30.4.20X6
28,571
value at 31.12.X5
18,182
Difference increases OCI and the financial asset
10,389
DEBIT
Financial asset
£10,389
CREDIT
Other comprehensive income
£10,389
2. The company sold its goods for $300,000 at 30.4.20X6 – this was a firm commitment in
dollars and then converted this at spot rate at 30.4.20X6
DEBIT
CREDIT
Customer £300,000/1.75
£171,429
£171,429
Revenue
There is now £18,182 + £10,389 = £28,571 in the financial asset as a debit balance and
£28,571 in the cashflow hedge reserve – an equity account - credit balance
This account is reclassified to profit or loss.
DEBIT Other comprehensive income
£28,571
CREDIT Revenue
£28,571
Revenue is measured at the amount fixed as a result of the hedging transaction i.e. £171,429
+ £28,571 = £200,000
7
The customer account and the financial asset are then cleared by cash receipts when the
customer pays, and the futures contract is settled.
£171,429
£171,429
DEBIT Cash
CREDIT Customer
DEBIT
£28,571
Cash - sale of futures contract
£28,571
CREDIT Financial asset
Question 6
On 1 July 20X6, a jewellery trader acquired 10,000 ounces of a material which it held in its
inventory. This cost £200 per ounce, so a total of £2 million.
The trader was concerned that the fair value of this inventory would fall, so on 1 July 20X6 he
sold 10,000 ounces in the futures market for £210 per ounce for delivery on 30 June 20X7.
On 1 July 20X6, the conditions for hedge accounting were all met.
At 31 December 20X6, the end of the trader's reporting period, the fair value of the inventory
was £220 per ounce while the futures price for 30 June 20X7 delivery was £227 per ounce.
On 30 June 20X7 the trader sold the inventory and closed out the futures position at the then
spot price of £230 per ounce.
Required
a) Explain whether the above transaction is a cashflow or a fair value hedge.
This is a fair value hedge – the trader is concerned about the fall in the fair value of inventory
on the balance sheet.
b) Set out the accounting entries in respect of the above transactions.
Record the purchase of inventory
1 July 20X6
£
Inventory
2,000,000
Cash
2,000,000
To record the initial purchase of material
8
At 31 December 20X6, the end of the trader's reporting period, the fair value of the
inventory was £220 per ounce – ie it now has a fair value of £2,200,000.
The increase in the forward contract liability was £170,000 (10,000 x (£227 – £210)) –
It is a liability because, the trader could have got the contract at 31 December 20X5 for
£227 and is locked in at £210.
Although this increase is not the same as the increase in the fair value of the inventory –
170,000/ 200,000 x 100 = 85% - means that it is 85% effective and IFRS 9 permits the
hedge to be recognised as such.
Debit
31 December 20X6
£
Profit or loss
170,000
Financial liability
(To record the loss on the forward contract)
Inventories
200,000
Profit or loss
(To record the increase in the fair value of the
inventories)
Credit
£
170,000
200,000
Normally this increase in the fair value of inventory of £200,000 is not recognised until it is
sold – this is the accounting rule under IAS 2 and IFRS 15. Because the company has
designated this as a hedge transaction – it is permitted to record the gain on the inventory
matching to the loss on the derivative contract.
At 30 June 20X7 the increase in the fair value of the inventory was another £100,000
(10,000 x (£230 – £220)) and the increase in the forward contract liability was another
£30,000 (10,000 x (£230 – £227)).
9
30 June 20X7
Profit or loss
Financial liability
(To record the loss on the forward contract)
Inventories
Profit or loss
(To record the increase in the fair value of
the inventories)
Debit
£
30,000
Credit
£
30,000
100,000
100,000
Inventory is now £2,000,000 + £200,000 +£100,000 = £2,300,000
Financial liability is now £170,000 + £30,000 = £200,000
Sell inventory for £230 per ounce
Debit
£
2,300,000
30 June 20X7
Profit or loss
Inventories
(To record the inventory sold
Cash
Profit or loss - revenue
(To record the sale of inventory)
Credit
£
2,300,000
2,300,000
2,300000
Settle the financial liability
Dr financial liability
200,000
Cr Cash
Being the settlement of balance on the financial
liability
200,000
Note that because the fair value of the material rose, the trader made a profit of only
£100,000 on the sale of inventories.
Without the forward contract, the profit would have been £300,000 (£2,300,000 –
£2,000,000). In the light of the rising fair value, the trader might in practice have closed
out the futures position earlier, rather than waiting until the settlement date.
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