22420 Chap.10 Financial Instruments: Classification and Measurement
Financial Instruments: Classification and Measurement
Holders: why is it held?
A financial asset is measured at amortised cost, at fair value through other comprehensive income or at fair value through profit or loss, depending on its contractual cash flows and the business model under which it is held.
Trade receivables sit at amortised cost; trading portfolios and derivatives sit at fair value through profit or loss.
Issuers: liability or equity?
Under AASB 132 the substance of the contract decides. A preference share that must be redeemed is a liability; one with discretionary payments is equity.
A convertible note is split, with the liability measured at the present value of its cash flows at the market rate and the residual in equity.
Why substance decides
Preference shares, convertible notes and redeemable instruments are where legal form and economic reality part company. The subject’s approach is to read the contract: who can force a payment, and is the number of shares fixed?
Those two questions settle most classification answers.
What this chapter covers
- 01
Financial asset, financial liability and equity instrument
- 02
Items outside the definitions
- 03
Contractual cash flow test and business model
- 04
Amortised cost, FVOCI and FVTPL
- 05
Preference shares: liability or equity
- 06
Offsetting under paragraph 42
- 07
Splitting a convertible note
- 08
Interest at the market rate on the liability component
Worked example · free
Splitting a convertible note between debt and equity
- 1Principal: $2,000,000 × 1.08^−3 = $1,587,664.
- 1Coupons: $100,000 × 2.577097 = $257,710, so the liability is $1,845,374.
- 1Equity option: $2,000,000 − $1,845,374 = $154,626.
- 1Year 1 interest: $1,845,374 × 8% = $147,630; cash of $100,000 is paid and the liability rises by $47,630 to $1,893,004.
Key terms
- Financial liability
- A contractual obligation to deliver cash or another financial asset, or to exchange financial instruments on potentially unfavourable terms.
- Amortised cost
- A measurement basis for instruments held to collect contractual cash flows, with interest at the effective rate.
- FVTPL
- Fair value through profit or loss, the basis for trading holdings and derivatives such as options and futures.
- Compound instrument
- An instrument with both a liability and an equity component, such as a convertible note.
- Business model
- How an entity manages a group of financial assets, for example to collect contractual cash flows.
Financial Instruments: Classification and Measurement FAQ
Why are some preference shares liabilities?
Because substance overrides legal form. A preference share that must be redeemed for cash, with non-discretionary dividends, works like a fixed-rate loan, so the issuer has an obligation it cannot avoid.
Are tax payable and employee provisions financial liabilities?
No. Income tax is levied by law rather than arising from a contract, and employee benefits, warranties and prepayments fall outside the definitions or the scope of the financial instruments standards.
When can a financial asset and liability be offset?
Only when the entity has a legal right, enforceable in court, to net the amounts and an intention to settle net or simultaneously. Derivatives with different counterparties do not qualify.
Which items look like financial instruments but are not?
A restoration provision, income tax payable, employee benefit provisions, product warranties and prepayments. Each lacks a contractual right or obligation to receive or pay cash or another financial asset, or is excluded by the scope paragraphs.
How is interest measured on a convertible note liability?
At the market rate for similar debt without the conversion option, applied to the opening liability. The difference between that interest and the cash coupon is added to the liability each year, so it grows to the face value by maturity.
Exam move
Practise the classification route on a mixed list of holdings until each takes a few seconds, saying the business model aloud. Then rebuild one convertible note split and its interest schedule to maturity, ending with both the redemption and the conversion entries. Close with a list of preference share terms and classify each for the issuer in under a minute.
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