Accounting for Financial Instruments and Derivatives, and Hedge Accounting (IAS 32, 39, IFRS 7, 9)

Applicable Standards

  • IAS 32 – Financial Instruments: Presentation
  • IAS 39 – Financial Instruments: Recognition and Measurement
  • IFRS 9 – Financial Instruments
  • IFRS 7 – Financial Instruments: Disclosures

IAS 32 – Financial Instruments: Presentation

Liability vs. Equity


  • A Financial Liability is any liability where the issuer has a contractual obligation:
    • to deliver cash or another financial asset to another entity, or
    • to exchange financial instruments with another entity on potentially unfavourable terms
  • An Equity Instrument is any contract that offers the residual interest in the assets of the company after deducting all of the liabilities.
  • An instrument is an Equity Instrument if
    1. There is no obligation to transfer cash or another financial asset to another party; and
    2. It will not be settled with a variable number of its equity instruments.

Preference Shares

  • Redeemable Preference Shares
    • Repurchased by the issuer at a fixed amount on a fixed date.
    • Classified as a Financial Liability.
    • Dividends paid to such shares are accounted as Finance Cost in Income Statement
  • Irredeemable Preference Shares
    • If it has a fixed cash dividend, that is a liability component.
    • If it is entitled to participate in dividends paid on ordinary shares, that is an equity component
    • Classified as a Compound Financial Instrument (see below)
  • ‘Normal’ Preference Shares
    • Typical preference shares come with a fixed dividend, preference in event of liquidation, but does not have rights to the residual interests in the company.
    • Hence they are classified as a Financial Liability.

Accounting for Cash Flows of a Financial Liability

  • All interest, dividend, losses, gains, are recognised as income or expense in P&L.

Accounting for Cash Flows of an Equity Instrument

  • Distributions to holders and transaction costs are debited directly to equity, net of any related income tax benefit.

Compound Financial Instruments

  • Instruments that contain both a liability and equity component needs to be split into these two components and recognised separately in the Balance Sheet.
  • Transaction costs incurred in issuance are allocated proportionately to the liability and equity values.

Convertible Debt

  • Valuation
    • Value of liability component = Debt component valued independently as if there was no conversion feature, using the market yield for straight debt.
    • Value of convertible bond = Original proceeds at inception, or FV subsequently
    • Value of equity component (i.e. the conversion feature) = Value of convertible bond – Value of liability component
  • Accounting at issuance
    • Dr Cash Proceeds
    • Cr Bond Liability with value of liability component
    • Cr Equity (convertible bond option proceeds) with value of equity component
  • For entity’s own issued debt, IAS 39 requires it to be classified as ‘Financial liability measured at amortised cost’. As the liability component was valued using the market yield at inception, the interest rate used for unwinding the discount is also the same market yield.
  • Accounting at conversion
    • Dr Bond Liability [eliminate the value at conversion]
    • Dr Equity (convertible bond option proceeds) [this didn’t change from issuance]
    • Cr Share Capital
    • Cr Share Premium

Treasury Shares

  • Shares bought back are either
    • Deducted from share equity; or
    • Offset against share equity and disclosed
  • Gains/losses are recognised in Other Comprehensive Income and not reported in P&L.

Offsetting Financial Assets and Liabilities

A financial asset and a financial liability can be offset and shown net in the Balance Sheet if the company

  1. Has a legal right to set off the amounts; and
  2. Intends to settle on a net basis, or settle the liability immediately when the asset is sold off.

IAS 39 – Financial Instruments: Recognition and Measurement

Note that IFRS 9 will be replacing IAS 39.

Financial Liabilities

Recognition Principle

  • Recognised once entity becomes a party to the contractual provisions of the instrument. Hence Forward contracts are recognised at inception even though the value would be zero.

Classes of Financial Liabilities

  1. Financial liabilities at fair value through P&L (FVPL)
    • Held for trading
  2. Financial liabilities measured at amortised cost (FLAC)
    • Held to maturity

Initial Measurement

  • Fair value, typically proceeds received.

Accounting for Transaction Costs (e.g. issuance cost) [This applied to both Financial Assets and Financial Liabilities]

  • If instrument is classified as FV through P&L (FVPL), then it is expensed in P&L.
  • Else, it is capitalised and lowers the FV of a liability or increases the FV of an asset.

Subsequent Measurement

  • FVPL
    • Re-measured to FV at each reporting date.
    • Gains/losses recognised in P&L.
    • Interest and dividends recognised in P&L.
  • FLAC
    • Measured at amortised cost (i.e. the same method as for provisions and operating lease accounting)
      • Opening balance
      • + Interest expense (original effective interest * opening balance)
      • – Actual interest paid
      • = Closing balance
    • Interest recognised as Finance Cost in P&L, using effective interest rate.
    • Note that eventually the total Finance Cost charged to P&L will be = Redemption value (can be a premium to the principal) + cash interest to be paid – initial recognition value.

Financial Assets (IAS 39 – to be superseded by IFRS 9 by 1 January 2013)

Classes of Financial Assets

  1. Financial assets at fair value through P&L (FVPL)
    • Held for trading
    • Derivatives
  2. Held-to-maturity investments
  3. Loans and receivables
    • Not quoted in an active market
  4. Available-for-sale financial assets
    • “Catch all” category

Initial Measurement

  • At cost, which is the same as FV at inception
  • Trade receivables are not discounted to present value because they are short-term.

Subsequent Measurement

  1. Financial assets at FVPL
    • FV at each reporting date
    • Gain/loss reported in P&L.
  2. Held-to-maturity investments
    • Carried at amortised cost
  3. Loans and receivables
    • Carried at amortised cost
  4. Available-for-sale financial assets
    • FV at each reporting date
    • Gain/loss reported in Other Comprehensive Income, and taken to an equity reserve (e.g. available-for-sale reserve)


  1. FVPL
    • Gain/loss taken to P&L.
  2. Available-for-sale financial assets
    • Cumulative gains/losses are removed from the equity reserve, and transferred to P&L.
    • Accounting entries
      • Dr Cash with sales proceeds
      • Cr Investment with carrying amount
      • Dr Available-for-sale reserve with cumulative gains/(losses)
      • Cr P&L with (carrying amount – sales proceeds + cumulative gains/(losses))
    • To prevent double counting since previous gains/losses were previously recognised in OCI, a matching loss/gain is entered into OCI (reclassification adjustment).


  1. Instruments at FVPL
    • Impairment loss recognised in P&L.
  2. Instruments carried at amortised cost
    • Impairment loss recognised in P&L
    • Carrying value on Balance Sheet either written down or offset by an allowance account.
  3. Instruments classified Available-for-Sale
    • Impairment loss recognised in P&L
    • Previously recorded loss in equity reserve (through OCI) also transferred to P&L.

Derecognition of Financial Assets and Liabilities

Derecognition criteria

  • Financial Asset – Contractual rights to cash flows expired or substantially all of the risks/rewards of ownership have been transferred. The financial asset is also derecognised if some risks and rewards are retained but control is lost.
  • Financial Liability – Obligations expired or discharged.

Accounting for Factoring

  • Without recourse (asset derecognised)
    • Transfer asset
      • Dr Cash
      • Cr Receivables
    • Account for fees
      • Dr Expense (P&L)
      • Cr Receivables
  • With recourse (asset retained)
    • Retain risk while receiving cash
      • Dr Cash
      • Cr Liability
    • Reduce risk while receivables are paid by customers
      • Dr Liability
      • Cr Receivables
    • Account for fees
      • Dr Expense (P&L)
      • Cr Receivables

IFRS 9 – Financial Instruments

Note that IFRS 9 will be replacing IAS 39. The following section is only on Financial Assets in IFRS 9, and does not cover Financial Liabilities in IFRS 9.

Financial Assets

Initial Measurement

  • Fair value

Subsequent Measurement

  • If Financial Asset is a debt instrument
    • The Financial Asset is measured at amortised cost if both of these two tests are passed, else it is measured at FV through P&L (FVPL):
      • Business model test
      • Contractual cash flow characteristics test
    • Business model test
      • Is the business model of the entity to trade assets or to collect contractual cash flows (i.e. hold to maturity)?
      • If hold to maturity, Pass, else Fail.
    • Contractual cash flow characteristics test
      • Does the contractual cash flows come on specified dates, and consist solely of principal and interest based on an outstanding principal?
      • If yes, Pass, else Fail (e.g. complex derivatives)
  • If Financial Asset is an equity instrument
    • If it is held for trading, measured at FVPL
    • Else entity can irrevocably elect to measure at FV through Other Comprehensive Income (FVOCI).
      • Dividends are still recognised in P&L, unless they are a recovery of part of the investment.
      • Fair value changes recognised in OCI, and flow through to an equity reserve (not retained earnings).
  • Regardless of the above, an entity can choose to irrevocably designate a Financial Asset at FVPL if it eliminates or significantly reduces a measurement mismatch (e.g. a closely related financial liability is measured at FVPL but the financial asset is otherwise made to be carried at amortised cost).


  • Financial Asset measured at FVPL
    • Account for the proceeds
      • Dr Cash (Balance Sheet)
      • Cr Gain/Loss on Disposal (Income Statement)
    • Account for the carrying value
      • Cr Investment (Balance Sheet)
      • Dr Gain/Loss on Disposal (Income Statement)
  • Financial Asset measured at FVOCI
    • On disposal, the equity reserve can be transferred to retained earnings without recycling through P&L.
    • [It is not clear whether the gain/loss on disposal goes to P&L or still to OCI.]

Accounting for Interest-Free Loans to Employees

  • The Financial asset is recognised and fair valued using the market interest rate.
  • The difference between the cash given out and the fair value of the financial asset is recorded as Employee Cost
  • Accounting entries
    • Cr Cash
    • Dr Financial Asset
    • Dr Employee Compensation [I’m not sure whether this is in P&L or is a Balance Sheet account that is amortised. In my view, it is more appropriately accounted for as a deferred asset if the loan terminates when the employee leaves because then the compensation captures future benefits that the company will receive from the employee. If the loan is independent of the employee’s employment with the firm, then I would be inclined to immediately expense it through P&L because then the compensation is for employee’s past services.]

Impairment of Financial Assets

  • Entities must assess, at the end of each reporting period, for
    • Objective evidence of impairment due to a ‘loss event’
    • The impact of the loss event on estimated future cash flows of their financial assets
  • Only losses (expected or realised) due to past events can be used for impairment, not expected losses from expected events.
  • Impairment is automatically handled for financial assets measured at fair value (either through P&L or OCI).
  • For financial assets carried at amortised cost
    • Impairment loss = PV (using original effective interest rate) of estimated future cash flows – carrying amount
    • Recognised in P&L and carrying amount either written down or set off against an allowance account.



A derivative must have all three characteristics below

  1. Its value changes in response to the change in another variable (which in the case of a non-financial variable, is not specific to a party to the contract);
  2. Its initial net investment is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
  3. It is settled at a future date.


  • Fair value through P&L (FVPL)

Embedded Derivatives


  • An embedded derivative is a component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.

An embedded derivative is separated from the host contract and accounted for as a derivative (and the host contract accounted for under its appropriate standard) if

  1. the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host;
  2. a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
  3. the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss.

A foreign currency denominated contract contains an embedded derivative unless it meets one of the following criteria:

  1. The currency is the functional currency of either party to the contract;
  2. The currency is routinely used in commercial transactions of the particular good or service (e.g. US$ for oil prices); or
  3. The currency is commonly used in such contracts in the market in which the transaction takes place (e.g. US$ in South America).

Despite the above, an entity may designate the entire hybrid contract as at FVPL unless:

  1. it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative is prohibited (e.g. prepayment option in a mortgage)
  2. the embedded derivative does not significantly modify the cash flows that otherwise would be required by the contract.

In IFRS 9, there is an additional key requirement that if a hybrid contract contains a host that is a Financial Asset under IFRS 9, then the entire hybrid contract is treated like a Financial Asset.

Hedge Accounting (IAS 39)

Types of Hedging Relationships

  1. Fair value hedge
    • Hedge against changes in fair value of an asset/liability or firm commitment, that could affect P&L
  2. Cash flow hedge
    • Hedge against variability in cash flows of an asset/liability or a highly probable forecast transaction, that could affect P&L.
  3. Hedge of a net investment in a foreign operation

Conditions to be met for hedge accounting to be used

  • Formal documentation at inception of hedge detailing the hedging instrument, hedged item, hedged risk, type of hedge, method of testing effectiveness, etc;
  • Hedge must be highly effective (change in hedging instrument / change in hedged item = 80% to 125%);
  • Hedge must be assessed regularly and found to be highly effective;
  • Hedge effectiveness can be reliably measured.

Fair Value Hedges


  • Gain/loss on the hedging instrument (measured at FV) recognised in P&L.
  • Gain/loss on the hedged item also recognised in P&L.

Cash Flow Hedges


  • Gain/loss on hedging instrument is split into ‘effective’ and ‘ineffective’ portions.
  • Effective portion is recognised in OCI, ineffective portion is recognised in P&L.
  • When the hedged item’s forecast cash flows affect P&L, the cumulative amount recognised in OCI is released to the P&L.
    • Dr Equity Reserve (through debiting OCI, as a reclassification adjustment)
    • Cr Income Statement

Hedge of a Net Investment in a Foreign Operation


  • A hedging instrument can be designated as a hedge against the changes in the value of the net assets of a foreign operation, provided that the value of the hedging instrument is <= the value of the net assets.
  • The hedging instrument can be held within any entity in the group.


  • Per IAS 21, foreign exchange differences during consolidation of the net investment in a foreign operation is recognised in OCI.
  • Gains/losses on the hedging instrument will also be recognised in OCI.

Disposal of Foreign Operation

  • Cumulative gain/loss on the hedging instrument will also be reclassified from equity reserve to P&L, along with the reclassification of foreign translation reserve to P&L.

IFRS 7 – Financial Instruments: Disclosures

Companies must disclose information that enables users to evaluate the

  • Significance of financial instruments for the entity’s financial position and performance; and
  • Nature and extent of risks, and how the entity manages those risks.

Significance of Financial Instruments

Statement of Financial Position Disclosures

  • Carrying amounts of financial assets and liabilities
  • Reclassifications and derecognition
  • Financial assets pledged as collateral
  • Reconciliation of assets with their allowance accounts.
  • Defaults and breaches for loans payable.

Statement of Comprehensive Income Disclosures

  • Net gains and losses on financial instruments
  • Interest income and expense
  • Fee income and expense
  • Impairment losses

Other Disclosures

  • Hedge accounting details
  • Fair value of financial assets and liabilities

Nature and Extent of Risks

Qualitative and quantitative disclosure of risks arising from financial instruments

  • Credit risk
    • Maximum exposure
    • Credit quality, enhancements
    • Carrying amount of impaired or ‘past due’ assets
  • Liquidity risk
    • Maturity analysis of financial liabilities
  • Market risk
    • Sensitivity analysis of each type of market risk to P&L and equity.
  • Other price risk



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