Financial Instruments
Measurement
Financial Instruments
Syllabus tag: KASNEB CPA | Advanced Level | CA32 Advanced Financial Reporting and Analysis | Topic 6 Financial Instruments
Lesson objectives
By the end of this topic, you will be able to:
- Distinguish a financial liability from an equity instrument
- Classify financial assets under IFRS 9
- Measure a liability at amortised cost using the effective interest method
- Apply the expected credit loss model
- Explain the purpose and conditions of hedge accounting
Why this matters
The classification decides everything that follows. Two instruments with identical cash flows can produce different profit, different gearing and different equity depending on how they are classified — which is why the definitions come first.
Liability or equity
A financial liability exists where there is a contractual obligation to deliver cash or another financial asset, and the entity cannot avoid it.
An equity instrument is a residual interest: no obligation to pay anything.
Substance over form governs. A redeemable preference share carrying a fixed dividend is a liability, whatever it is called, because the company must redeem it and must pay the dividend. Its "dividend" is presented as a finance cost, not a distribution.
An ordinary share is equity, because dividends are discretionary and the capital need never be returned.
The consequence matters commercially: classifying an instrument as a liability raises gearing, reduces reported equity, and moves the return from below the profit line to above it.
Classification of financial assets
Two tests, applied together:
- The business model — is the asset held to collect contractual cash flows, to collect and sell, or to sell?
- The cash flow characteristics — are the cash flows solely payments of principal and interest (the SPPI test)?
| Business model | SPPI met? | Measurement |
|---|---|---|
| Hold to collect | Yes | Amortised cost |
| Hold to collect and sell | Yes | Fair value through OCI |
| Any other, or SPPI failed | — | Fair value through profit or loss |
An equity investment always fails SPPI, since a share pays no principal or interest. It is measured at fair value through profit or loss, unless an irrevocable election is made at initial recognition to present changes in OCI — an election available only for equity instruments not held for trading.
That election has a consequence: amounts recognised in OCI on such an investment are never reclassified to profit or loss, even on disposal. The gain never appears in earnings at all.
Amortised cost and the effective interest method
A bond of KES 50,000,000 is issued at 96 with issue costs of 800,000, paying an 8% coupon, with an effective interest rate of 9.6%.
Net proceeds = 48,000,000 − 800,000 = KES 47,200,000
| Year | Opening | Interest at 9.6% | Coupon paid | Closing |
|---|---|---|---|---|
| 1 | 47,200,000 | 4,531,200 | (4,000,000) | 47,731,200 |
| 2 | 47,731,200 | 4,582,195 | (4,000,000) | 48,313,395 |
The finance cost is 4,531,200, not the 4,000,000 actually paid. The difference accretes onto the liability, which climbs towards the redemption value. Issue costs are deducted from the proceeds, never expensed immediately — that is what raises the effective rate above the coupon.
:::checkpoint A candidate charges the KES 4,000,000 coupon as the finance cost and expenses the issue costs when incurred. State the two effects on the financial statements. :::
Expected credit losses
IFRS 9 requires losses to be recognised before a default occurs, on a forward-looking basis. The incurred-loss model it replaced recognised losses only once there was objective evidence — which reliably produced provisions that arrived too late.
Three stages:
| Stage | Condition | Loss allowance |
|---|---|---|
| 1 | No significant increase in credit risk | 12-month expected losses |
| 2 | Significant increase, not credit-impaired | Lifetime expected losses |
| 3 | Credit-impaired | Lifetime, with interest on the net carrying amount |
A receivable of KES 40,000,000 with a 2% 12-month default probability and 25% loss given default:
Stage 1 allowance = 40,000,000 × 2% × 25% = KES 200,000
If credit risk increases significantly and the lifetime probability is 12%:
Stage 2 allowance = 40,000,000 × 12% × 25% = KES 1,200,000
The transfer to stage 2 costs 1,000,000 without any default having occurred. The trigger is a change in risk, not a change in outcome.
Trade receivables may use the simplified approach: lifetime expected losses from the outset, avoiding the need to monitor stage transfers on a large population of small balances.
Hedge accounting
Hedge accounting exists to correct an accounting mismatch — where a hedge is economically effective but the instrument and the hedged item would otherwise be measured differently, or recognised in different periods.
| Type | Hedges | Treatment |
|---|---|---|
| Fair value hedge | Exposure to changes in fair value | Both the instrument and the hedged item to profit or loss |
| Cash flow hedge | Variability in future cash flows | Effective portion to OCI, recycled when the item affects profit |
| Net investment hedge | A foreign operation | Like a cash flow hedge, recycled on disposal |
Conditions: formal designation and documentation at inception, an economic relationship between the instrument and the hedged item, credit risk not dominating the value changes, and an appropriate hedge ratio.
Hedge accounting is optional and it is a choice about presentation. The economic hedge exists whether or not it is applied; what hedge accounting changes is when and where the gains and losses appear.
:::checkpoint A company hedges a forecast purchase with a forward contract but does not document the relationship at inception. State whether hedge accounting may be applied and what appears in profit or loss instead. :::