Lecture # 15

Presentation of Financial Instruments

Definitions:
Routine Assets
 Land, building, Plant & Machinery, Furniture & Fixtures etc.
 Stocks, Receivables, Short term Investments & Cash etc.
Financial instrument:
A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of
another entity.
Financial asset:
A financial asset in one entity, and
a financial liability or equity instrument in another entity. A financial asset is any asset that is:
 Cash;
 An equity instrument of another entity; A contractual right:
to receive cash or another financial asset from another entity; or
to exchange financial assets or financial liabilities with another entity A financial liability is any
liability that is a contractual obligation:
to deliver cash or another financial asset to another entity; or
to exchange financial assets or financial liabilities with another entity under conditions that are
potentially unfavorable to the entity.
Financial instruments include:
Cash, Shares, Loans, Debentures Accounts receivable or accounts payable; and Financial derivatives and
commodity derivatives, currencies etc.
Derivatives

A contract between two or more parties to receive a financial security whose value is dependent upon
some underlying assets.

A derivative is a financial instrument with all three of the following characteristics:

 Its value changes in response to a specified underlying (interest rate, commodity price,
exchange rate etc.)
 It requires no or little initial investment
 It is settled at some future date
For Example a loan obtained today shall be settled after one year in US$ terms at the rate prevailing at a
certain date after one year.

Forward Contract
A private agreement between two parties giving the buyer (an obligation to purchase an asset)
and the seller (an obligation to sell) at a set price at a future point in time.
A contract like this will require no initial outlay by the company (it has zero fair value at the
date it is entered into). Over the life of the contract its fair value will depend on the spot
exchange rates and the time to the end of the contract.

Example-Forward Contract

A Pakistani company enters into a 6 month forward contract to buy US $100,000 at a rate of Rs. 160 = $1

This means that the Pakistani company will pay Rs. 16,000,000 to buy $100,000 in 6 months’ time.
This removes uncertainty for the Pakistani company.
A simple valuation of the forward can be made at any time over the life of the contract by
comparing the contracted rate to the spot rate.

Spot rate at date of valuation

Rs. 150 = $1 Rs. 170 = $1
Cost of $100,000 under forward contract Rs. 16,000,000 Rs. 16,000,000
Cost of $100,000 on open market Rs. 15,000,000 Rs. 17,000,000
Difference Rs. 1,000,000 Rs. 1,000,000
Pakistani company would recognize: a liability an asset

Future Contract

It is a legal agreement generally made on the trading floor of a future exchange to buy or sell a
particular commodity or financial instrument at a predetermined price at a specified time in
future.

Option Contract

An agreement between a buyer and seller that give the purchaser an option /right to buy or sell
a particular asset at a later date at an agreed price.

Example: A trader buys an option contract with the intention that if company’s stock price go up
he has the option to buy the shares of that company.

The Classes of Financial Assets and Subsequent Measurement

On initial recognition, financial assets are classified into one of four categories. This
categorization is very important as it determines the subsequent measurement of the
financial asset.

1. Fair value through profit or loss

2. Held to Maturity Investments.
3. Loans & Receivables.
4. Available for Sale

Fair Value through Profit & Loss

This includes financial assets that are held for trading purposes and not to maintain ownership.
When these assets are being held, they are always recorded at fair value on the balance sheet,
and any changes in the fair value are recorded through the income statement, eventually
affecting net income for that particular year. All transaction costs associated with the investment
are expensed immediately.

Example: XYZ Company purchased an investment on November 1, 2016 for $1,000. At

December 31, 2016, the fair value of the investment is $3,000. Transaction costs are 4% of
purchases. What are the journal entries?

Nov 01, 2016 Dr Cr

Investment 1,000
Cash 1,000

Income Statement-Transaction 40
Expense
Cash 40

Dec 31, 2016 Dr Cr

Investment 2,000
Unrealized Gain 2,000

Derivatives that are assets must be included in this category unless held in hedging
purposes. An entity can choose to treat other financial instruments as ‘at fair value
through profit or loss’, provided that they meet certain criteria.

Held to maturity investments. These are financial assets with fixed payments and a fixed
maturity that the entity intends to hold until their maturity. Such Instruments are usually quoted
in the active market (i.e. stock exchange). An example is an investment in bonds issued by
another entity, where there is no intention to sell the bonds on the market before their maturity.

Loan stock (Debentures), redeemable preference shares and bonds issued by other entities
also fall into this category, provided that the entity plans to hold the investment to the end of
its term (for example, when it is redeemable).

Loans and receivables. These are assets with fixed payments but are not quoted in an
active market. They include regular bank loans and accounts receivable (trade receivables).
They are not expected to be sold in the near future.

This category could include loans made to other entities, trade receivables and investments in
bonds and other forms of debt, provided that the other conditions are met.
Available-for-sale financial assets. These are any other financial assets that do not fall into
any of the three categories above. In addition, an entity can designate an asset as available-
for-sale when it is first recognized.
Categories of financial liability and Subsequent Measurement
On initial recognition, financial liabilities are classified into one of two categories.
This categorization determines the subsequent measurement of the financial liability.
There are two categories of financial liabilities:

At fair value through profit or loss. These include derivatives that are liabilities unless held
for hedging purposes.

Measured at amortized cost. This category is for all remaining financial liabilities.
Practice Questions
Example # 1

An equity investment is purchased for Rs. 30,000/- plus 1% transaction cost on Jan 01, 2016. It is
classified at fair value. At the end of the financial year on 31.12.2016 the investment is revalued at
Rs.40,000/- The said investment is sold on 11.12.2017 for Rs.50,000/-

Please explain the accounting treatment, Presentation and disclosure