FINANCIAL INSTRUMENTS: MEASUREMENT

The measurement of financial instruments can be divided into two parts, i.e. on initial recognition (how a financial asset or liability should be measured when it is first acquired or incurred) and subsequent to initial recognition (how a financial asset or liability should be measured at the reporting date).

Initial recognition

On initial recognition, all financial assets and liabilities should be measured at their fair values, i.e. the fair value of the consideration paid or received.

Directly attributable transaction costs are added to a financial asset and deducted from a financial liability except for financial assets and liabilities classified as measured at fair value through profit or loss.

Subsequent recognition

Subsequent to initial recognition, the measurement rules for each category of financial assets and liabilities are as follows:

Financial assets		Measurement and accounting
(i)	Measured at amortised cost	At amortised cost.
(ii)	Measured at fair value through profit or loss (FVTPL)	At fair value with gains and losses recognised in profit or loss.
(iii)	Measured at fair value through other comprehensive income (FVTOCI)	At fair value with gains and losses recognised in other comprehensive income. However, dividends received on such investments are recognised in profit or loss. On disposal of such investments, the gains or losses previously recognised in OCI are reclassified to profit or loss as they are considered to have been realised.
(iv)	Measured at cost	At cost.

Financial liabilities		Measurement and accounting
(i)	Measured at fair value through profit or loss (FVTPL)	At fair value with gains and losses recognised in profit or loss.
(ii)	Measured at amortised cost	At amortised cost.

The FVTPL and FVTOCI measurements are pretty straight forward. All we need to do is revalue those financial assets and liabilities to their fair values at each reporting date.

For financial assets, if their fair values have increased, then a gain arises and if their fair values have decreased, a loss arises. Such gains or losses are recognised in profit or loss or OCI depending on which category the financial assets are classified.

In the case of financial liabilities, if their fair values have increased, a loss arises and if their fair values have decreased, a gain arises. Such gains or losses are recognised in profit or loss.

Consider the following illustrations.

Illustration 1

Entity A purchased equity shares for $100,000 and classified them as measured at fair value through profit or loss. Legal fee of $1,000 was incurred in connection with the purchase. At the year end, the shares have a fair value of $120,000.

Required:

(a) How should the shares be accounted for?

(b) If the shares were classified as measured at fair value through other comprehensive  

     income, what would be the accounting entries?

Solution

(a) On initial recognition, the shares should be measured at their fair values, i.e. the fair value of 

     the consideration paid amounted to $100,000. As the shares are classified as measured at fair

     value through profit or loss, the legal fee cannot be added to the financial asset and must be

     expensed.

	Dr	Financial asset	$100,000
	Dr	Profit or loss	$1,000
	Cr	Cash	$101,000

     At the year end, the fair value of the shares have increased to $120,000 giving a gain of $20,000

     ($120,000 - $100,000), which should be recognised in profit or loss.

	Dr	Financial asset	$20,000
	Cr	Profit or loss	$20,000

(b) If the shares are classified as measured at fair value through other comprehensive income, the
     legal fee can be added to the financial asset. The accounting entry on initial recognition would

     therefore be:

	Dr	Financial asset (100,000 + 1,000)	$101,000
	Cr	Cash	$101,000

     At the year end, the fair value of the shares have increased to $120,000 giving a gain of $19,000

     ($120,000 - $101,000), which should be recognised in other comprehensive income.

	Dr	Financial asset	$19,000
	Cr	Other comprehensive income	$19,000

Illustration 2

Aztech purchases equity shares in a company that they wish to keep forever. The cost was $500
and by the year end the value had risen to $540. Then shortly after the year end, the company
changes its plans and sold the equity shares for $560.

Required:
Discuss and explain the options available to Aztech in accounting for the financial asset above.

Solution

The financial asset cannot be classified as measured at amortised cost as it is an equity instrument. Therefore, by default, it should be classified as measured at fair value through profit or loss (FVTPL).

However, as Aztech wishes to keep the shares forever, they are not held for trading. Therefore, Aztech could make an irrevocable election to classify the financial asset as measured at fair value through other comprehensive income (FVTOCI).

The accounting treatment is as follows:

Measured at FVTPL

On initial recognition, the financial asset is measured at the fair value of consideration paid:

	Dr	Investments in equity instruments	$500
	Cr	Cash	$500

At year end, the financial asset is remeasured to fair value with changes recognised in profit or loss:

	Dr	Investments in equity instruments	$40
	Cr	Profit or loss	$40

On disposal, the financial asset is derecognised and the gain of $20 ($560 - $540) is recognised in profit or loss:

	Dr	Cash	$560
	Cr	Investments in equity instruments	$540
	Cr	Profit or loss	$20

Measured at FVTOCI

On initial recognition, the financial asset is measured at the fair value of consideration paid:

	Dr	Investments in equity instruments	$500
	Cr	Cash	$500

At year end, the financial asset is remeasured to fair value with changes recognised in other comprehensive
income:

	Dr	Investments in equity instruments	$40
	Cr	Other comprehensive income	$40

On disposal, the financial asset is derecognised and the gain is recognised in profit or loss. At the same time, the gain previously recognised in other comprehensive income is reclassified to profit or loss:

	Dr	Cash	$560
	Cr	Investments in equity instruments	$540
	Cr	Profit or loss	$20

	Dr	Other comprehensive income	$40
	Cr	Profit or loss	$40

Amortised cost

Amortised cost is the cost of an asset or liability adjusted to achieve a constant effective rate of interest over the life of the asset or liability.

It is not possible to compute amortised cost for instruments that do not have fixed or determinable payments, such as equity instruments, and thus such instruments cannot be classified into this category.

An entity must apply the effective interest rate method in the measurement of amortised cost. It determines how much interest income or interest expense should be reported in profit or loss.

Illustration 3

Travolta bought a debenture off the market with a nominal value of $10,000. The coupon rate is 2%, but the effective interest rate is 7%. The debenture is redeemable after three years at a premium of $1,607. Travolta plans to hold the debenture until maturity.

Required:
How should the debenture be accounted for in the financial statements of Travolta?

Solution 

As Travolta intends to hold the debenture until maturity, the business model of holding financial assets to collect contractual cash flows is met. Therefore, the debenture should be classified as a financial asset measured at amortised cost.

On initial recognition, the debenture is measured at the fair value of consideration paid, i.e. $10,000.

	Dr	Debenture asset	$10,000
	Cr	Cash	$10,000

Subsequent to initial recognition, the debenture is measured at amortised cost as follows:

End of Year	Opening	Effective	Cash	Closing
	balance	interest at 7%	received	balance
	$	$	$	$
One	10,000	700	(200)	10,500
Two	10,500	735	(200)	11,035
Three	11,035	772	(200)	11,607

As we can see from the table above, the amount recognised on initial recognition, i.e. $10,000 is adjusted each year using the effective interest rate. As this is a financial asset, the effective interest will be recognised in profit or loss as an income. Annual payments of $200 from the debenture issuer will reduce the carrying amount of the financial asset accordingly. At the end of Year Three, Travolta will receive $11,607 ($10,000 nominal + $1,607 premium) from the debenture issuer as the redemption sum.

The double entries under the amortised cost measurement are as follows:

At end of Year One:

	Dr	Cash	$200
	Dr	Debenture asset	$500
	Cr	Profit or loss (Finance income)	$700

At end of Year Two:

	Dr	Cash	$200
	Dr	Debenture asset	$535
	Cr	Profit or loss (Finance income)	$735

At end of Year Three:

	Dr	Cash	$200
	Dr	Debenture asset	$572
	Cr	Profit or loss (Finance income)	$772

On redemption:

	Dr	Debenture asset	$11,607
	Cr	Cash	$11,607

Note that the illustration above shows the treatment of a financial asset measured at amortised cost. In the case of a financial liability measured at amortised cost, the workings are similar except that the effective interest would be recognised as a finance cost in the Income statement and the carrying amount of the financial liability would be reduced by annual instalments 'paid' instead of 'received'.