 Hello and welcome to this session. This is Professor Farhad and this session we're going to be looking at IFRS 32, which is financial instrument in specifically presentation. This topic is covered in international accounting course, the CPA exam very briefly and the ACCA exam. As always, I would like to remind you to connect with me if we haven't connected yet. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing and tax lecture. If you haven't subscribed to my channel, please subscribe. If you like my videos, please click on the like button, share them, put them in playlist, let the world know about them. If you're benefiting from my YouTube, it means other people might benefit as well. So share the wealth. This is my Instagram account. Please follow me on Instagram. This is my Facebook. I do have a few premium account on Gumroad and this is my website. On my website, if you'd like to, you can donate to support the channel. That's a greatly appreciated. Also on my website, I do have constant offers. For example, right now, Becker is offering $1000 off. Now, this price might intimidate you. That's a lot, but that's including all the whistles and everything. You don't have to purchase the whole course. You can purchase pieces of the course and now the course is has unlimited access. So once you buy it, you have access to it forever. So if you are studying for your CPA exam or planning to study or taken a particular course at the college, you can sign up for one part of Becker. You can supplement. Becker has altogether over 10,000 plus multiple choice, true, false and not true, false multiple choice and exercises. If I was in your shoes, I will take advantage of it. Okay. And also Becker does finance 0% financing. So if you're looking to finance, you don't have all the money upfront. Once again, you don't have to pay for the whole thing. You can buy it and pieces, whatever you need to have. So today we're going to focus on IAS 32, which is financial instrument presentation. So what is that? Well, I have IAS 32 define basically very specific. It defines a financial instrument as any contract that give the that give the rise to both a financial asset of one entity and a financial liability or equity of another entity. That's all what it does. Oh, we're going to be learning today is in a sense, basic definition of those fine. What are they? What are financial assets? What are they financial? What are financial liabilities? We're not going to look at recognition. We're not going to look at how we measure them. We're not going to look at how do it disclose them? Are we going to do that? Obviously, yes, but in a separate recording and a separate and a separate IFRS section, but today we're only going to have to learn what is a financial asset. So if I say it, this is a financial asset in the in the following session, you know what a financial asset is. Okay. What if I said a financial liability or an or an equity instrument? So what is a financial asset? Financial asset is defined as an any any asset. That's obviously cash cash is a financial asset, which we all we are all familiar with cash. That's easy. A contract right, a contractual right, not a contract, a contractual right. What is a contractual right? Well, you have the right to receive financial, another financial asset. When do you have the right to receive another financial asset? Well, guess what? If you buy a debt instrument, if you buy a debt investment, what is a debt investment when you buy a bond? When you buy a bond, you credit cash $100,000 and you debit some sort of a debt investment. So that investment is basically you bought a bond. You bought a bond. That investment. Let's assume $100,000. Okay. What happened is you bought a bond by buying a bond. That's going to give you the right to receive cash. What type of cash interest? And also it's going to give you the right to receive the principal amount. Same thing if you lend money, notes receivable. If you if you lend money $100,000, you will debit notes receivable, basically the same concept. Also a contractual right that to give you the right to exchange a financial asset or a financial liability under favorable condition. Here we are talking about call option and put option. What are call option and put option? Call option gives you the right to buy an asset, to buy a stock, an equity at a certain price. And put option gives you the right to sell. Don't worry about calls and pull. We're going to calls and pull option. We're going to cover them in a separate recording in a separate chapter. We're going to talk a lot about them. But this is what the definition of a financial asset is also an equity instrument. Basically what is an equity instrument? An equity instrument, basically a stock, basically an investment of another entity. So basically you bought a stock and another entity. So let me just show you. Let's assume you have $100,000. You bought an equity investment in Amazon. It's the stock symbol. So you debit $100,000 and you credit cash $100,000. So that's also a financial asset, an equity instrument. It's a financial asset that you purchase. You purchase a contract that will may or may not be settled in the entity's own equity instrument. And it's not classified as an equity instrument of the entity. So it's not your equity instrument. You're not Amazon. You purchase, you happen to have some extra cash. And you decided, you know what? I'm not going to keep that extra cash in the bank. I'm going to go ahead and buy an equity instrument. What is that equity instrument? Stocks and Amazon. Stocks and Amazon. Now we have to be very careful when we talk about equity instrument because depending on how much you buy of that equity instrument, determine how you account for it. For example, investment in equity instrument that are accounted for under the equity method or the consolidated method would not fall under the scope of IS-32 or IFRS-9, which is we did not talk about IFRS-9, but it doesn't fall under the scope of IFRS-9. What is the equity method and what's the consolidated method? Well, it all depends how much is your investment in that particular company. Let me show you on a timeline what we are looking at. This is zero and this is 100% of the company. As long as you buy less than 20%, you are considered to have what's called a passive interest. Passive interest means really you have no saying in the company you're a passive investor. Therefore, you would use what I just showed you here. This is an equity instrument. Once you have more than 20% up to 50%, once you fall it within this range, once you fall within this range, so you have more than 20% equity, but you're still less than 50%, then you are considered to be using the equity. Well, we are considered to have significant influence. Let's use the term significant influence. It means you have some influence over the company, significant influence. Under those circumstances, you have to use a method called the equity method. You have to use the equity method. Once you have more than 50%, once you own more than 50% of a particular company, more than 50%, then you have to use the consolidation, consolidate, consolidate the subsidiary. So what does that mean? It means when we're defining the financial instrument here, we are assuming you own less than 20%. So only those investment and equity that result in less than significant influence over the other entity, sometimes they're labeled as marketable securities are accounted for in accordance with IAS32 and IFRS9, which is again, don't worry about IFRS9. So we're dealing with stocks. You own the stocks, but it's less than 20%. What are we talking about this now? You're going to see in the next session when we try to recognize them and measure them, we have to know what type of assets are we dealing with. So that's very important. So that's what a financial asset is. Let's talk about the financial liability. Well, a financial liability is a contractual obligation to deliver cash or other financial asset. Think about when you sell a bond, when you sell a bond, when you raise money using bonds, guess what? You're going to have to pay interest. You're going to have to transfer or deliver cash to another party. For example, the financial asset holder is the financial asset holder that would receive the cash. You would have a financial liability. Why? Because now you need to pay the cash. So notice maybe this is interesting. Notice financial liability. It's going to ask you to deliver cash or another financial asset. Let me just erase this and highlight financial asset. Just show you it's kind of the opposite of it. If you look at financial asset, the definition of financial asset, it's the right to receive cash from another entity. Notice, so one company could have a financial liability. The other side will be the financial asset. Or to exchange financial asset or financial liabilities under potentially unfavorable condition. Again, here we're talking about calls and options, but you might be written those calls and options. Okay. Also a contract that will or maybe settle in the entity own equity instrument. So sometime you have to pay off your liability using your own equity instrument. In other words, you have a bond, but what's going to end up happening is you're going to pay off that bond maybe issuing some equity instrument, your own equity instrument. It means your own company stocks. So you would exchange the bond with stocks. That's what we are talking about here. Example of financial liabilities include payables, loans from other entities. When you borrow money, you have a notes payable. When you borrow money, you have a notes payable. Notice the lender will have a financial asset. You will have a financial liability. The lender will have a financial asset. You will have a financial liability. Issue bonds. Again, you issued the bond. You have a financial liability. The person that buys the bond will have a financial asset because they have an investment in you. Other debt instrument and obligation to deliver an entity own share for a fixed amount of cash. Again, any debt that you're going to have to deliver stocks for which kind of convertible debt. That's a financial liability written put option. When you write a put option, when you are responsible for buying that put option, those are financial liability. Equity instruments. What are equity instrument? Equity instruments are defined as any contract that evidence a residual interest in the asset of an entity after deducting its liability. That's what an equity instrument is. But equity instrument, you know, what does not include, it does not include, which we talked about this in addition to subsidiaries and equity method investing. So we talked about subsidiaries and equity method investing. This is where you own 50% plus. This is where you own between 50, 20 to 50. You own 20 to 50 use those method. The following are executed from the scope of IAS 32 insurance contract. That's not considered an equity instrument. An employer's right and obligation under employee pension plan, which is benefit plan, which is a pension. That's not included. We looked at this in a separate recording. Share-based payment program. Again, we looked at share-based payment program. That's not equity instrument. Transaction in the entity's own equity instrument, such as treasury stock, those are not considered equity instrument. Okay. Now, let's take a look at some time where you have a liability or an equity. So sometime you have an instrument and it has the feature of a liability and features of equity. Well, let's talk a little bit about what is a liability and what is an equity. When we say liability, it means you have debt. What does debt imply? Debt implies you have to pay back the money. Okay. So if I lend you money, if I gave you money, I gave you money. So there we go. You have two individuals. Okay. This is one and this is two. I gave you money and you gave me in return an instrument. Now, I don't know what that instrument is, but we have a deal between us and the deal says, you're going to pay me. I gave you money. I gave you $100,000 and here's what's going to happen. You're going to be paying me back, making payment, making payments. Now, you did not define the payment. I can call those payment interests. I can call those payment dividend. Okay. Because I gave you the money, but we really did not define the term whether it's interest or dividend. But here's what's going to happen. You told me, in addition to the interest and the payment, you're going to pay me back this money, $100,000, 10 years from now. Well, guess what? If you pay back the money, if you're going to be paying me back the money, we have a loan. We have a liability. Okay. But let's assume we're not going to pay me back the money. I gave you the money and you're going to be receiving interest and dividend. And what's going to happen is I'm going to give you some equity interest. I'm going to let you vote. I'm going to let you have a decision in my company. Then what I have is an equity. Okay. So the point is you have to know what is the contractual obligation here. So you have to read the agreement sometime if it's not clear to determine whether we are dealing with an equity instrument or a liability instrument. So I asked 30 to require financial instrument to be classified as financial liabilities. Am I buying a debt? Am I investing in debt or am I investing in equity? Or both in accordance with or both or is it both? It's an equity and a liability, which we'll see some some some instrument will be both. We have to look at the substance of the contractual agreement arrangement and the definition of the financial liability and equity. If an equity instrument contain a contractual obligation that meets the definition of a financial liability, it means you're calling it an equity, but it's not really an equity because you have to give me back the money. Then it should be classified as a liability. You might call something stocks like preferred stocks. Well, guess what? That sounds like stock. That sounds like equity. But if you said this is a preferred stock and going to give you back your money, then it's not a preferred stock. You basically I gave you a loan. Therefore it's a liability even though it's legal form is that of an equity instrument. So if it sounds if it sounds like a liability, but you call it equity, it's a liability. Okay. For example, if an entity issue preferred shares that are redeemable, redeemable means the shareholder can come back at any time and get their money back. And the entity cannot avoid the payment of the cash to shareholder and the company cannot say, well, I'm not going to pay you back. Okay. If they redeem them, you have no option. You have to give them back their money. Then what you're looking at is a liability, not equity. Although you call them preferred stock. Well, stock is equity. But if I can go back and ask you back for my money, it's not it's not equity anymore. Preferred shares are contingently redeemable based on future event outside the control of either the issuer or the shareholder also would be classified as a financial liability. Sometime it's a preferred stock. But what happened is it's redeemable if something happened. So if something happened, I have the right to go back and get my money back. Well, guess what? That's not stocks. This is not how stocks work. This is not how equity work. Equity basically, once you make that investment, that's your investment. You can go back to the company and say, I want my money back because you did not lend them the money. If a preferred stock is contingently redeemable, contingently means if something happened, what could be an example? Let's assume your stock price, your common stock price reaches a certain number. Okay. Or falls below a number. Or your retained earning falls above a number or below a number. It's a contingent upon something happening. Then I can go back and get my money. Guess what? We're not looking at an equity anymore. This sounds like a liability. So if it sounds you can get your money back. It's a liability. It's a loan. Let's take a look at an example to see how this work on October 29th, year one. This company issued 1 million 5% preferred stock preferred shares at par value. Okay. The preferred shares have a right to force the company to redeem the share at par value. So guess what? Well, there's even a contingency. If the Federal Reserve Bank interest rate rise above 5%, they'll be more specific. So this is the contingency. So the company, they have to buy it back from you if the Federal Reserve Bank interest rise above 5%. This is what a contingent liability is. Well, guess what? It's contingent. Guess what? Is this a stock or is this a debt now? Well, guess what? Now it's a debt. Why? Because there is a contingency to pay it back. On December 10th, year three, the Federal Reserve interest reaches that level. Because a future event that triggered the redemption of the preferred stock is outside the control of both the company and the shareholder, the 5% preferred shares must be classified as a liability. Therefore, they will debit cash, a million, and they will credit redeemable preferred share liability, a million. Okay? Under U.S. Gap, it's treated differently. The preferred shares initially would be classified as equity. Then on December 10th, year three, what's December 10th? December 10th, year three is when the Federal Reserve raised the interest rate to 5%. Once that happened, then we would reclassify the liability. So first, under U.S. Gap, it will be a preferred stock. So you will debit cash. Under U.S. Gap, you will debit cash. And you will credit preferred stock for the million. Then on December 10th, you will debit preferred stock for a million and create a liability. Why do you create a liability? Because now it's a liability. It's no longer equity. You have to take it out of the preferred stock and put it into a liability, a bond or whatever you want to call it. Whatever liability you want to call it. Just call it a liability. Okay? So this is whenever you have either an equity or a liability. This is how U.S. Gap treated. Sometime what we're going to have is a compound financial instrument. What's a compound financial instrument? It's a financial instrument that had the feature both of an equity and a liability. So we're looking at something that has the feature of both. Well, it has the feature of an equity and it has a feature of a liability. What are we looking at? What are we looking at? Well, we're looking at, for example, convertible bond. Okay? Compound financial instrument can contain both a liability element and an equity element. Should be split between the two components that are reported separately. So now here what's going to happen is we have two instruments. Although it's one contract, although it's one financial instrument, but we really have two things to account for. This is what we call split accounting. Convertible bond is a classic example for a compound financial instrument. From the issuer's perspective, the bond is comprised of two components. So when a company sells a convertible bond, guess what? They're selling you a contractual obligation to make cash payment of interest and principal as long as the bond is not converted. Well, guess what? They're giving you a bond and they have to pay you cash for the interest and they have to pay you back your money. This sounds like a financial liability. That's part of the bond. The second part of it, it has a call option that grant the bond holder right to convert the bond into a fixed number of common stock. Well, this is an equity instrument. This is an equity instrument. Hold on. So what is it? Is it debt or is it liability? It's both. It has the feature. It has the feature of both. It has a bond. It's a bond. You have to make interest payment, but also it has a call option comes with it. Under the split accounting, the initial carrying amount of the liability and the equity are determined using what we called with and without method. So what we have to do is when we sell the bond, we're going to get one price. When we sell the bond, when we sell the convertible bond, the company will receive one price. So they have to determine how much of that money is for the bond and how much that money is for the call option for the equity component because it's an instrument that it's a compound financial instrument. It has both. It has a bond and the liability, not either or it has both. Okay. So the fair value of the financial instrument with conversion feature is determined. So basically we'll try to determine what is the fair value of the whole of the whole deal. So let's assume for the whole deal here, we said this is I'm just going to make up this number $5 million. Okay, so so we sold the bond at $5 million and that include the bond feature and the equity feature. Then we'll try to determine the fair value of the financial instrument without the conversion feature. Then we say, okay, if the whole thing is $5 million, we're going to find the fair value of the equity and we say the value of the equity is $200,000. So we're going to subtract $200,000 from the equity for the equity component. So we say the equity component is worth $200,000. Well, guess what? Then the bond is $4.8 million. Then the bond value is $4.8 million. So we take out the difference, the difference between the fair value of the instrument as a whole and the amount separately determined for the liability component allocated to the equity component. Well, the $200,000 is allocated to the equity. We take it out. What's left for the bond for the liability or the bond, whatever you want to call it liability or bond is $4.8 million. This is what we do. Now, under US GAAP, we have the incremental method. We can use something called the incremental method or the proportional method similar, but not the same. Note that a compound financial instrument is a financial asset for the holder of the instrument. So if you bought this instrument, if you bought a convertible bond, you have a financial asset. The company that issued it will have a financial liability. As I told you, what's financial asset for one party is a financial liability for the other? Let's take a look at an example to see how this all worked. Sharma Corporation issued 2 million 4% convertible bond. Notice it's convertible. The bond has a five-year life with interest payable annually. So far, so good. Each bond has a face value of $1,000 and is converted at any time up to maturity for 250 shares of common stock. So the bond holder bought the bond. But guess what? This bond is great. Why? Because if the company is doing really well, you can convert the bond. You can convert each bond for shares. It's a convertible bond. So it has a bond. It has a liability feature. I'm going to get my interest. Then the company said, look, if you like to switch teams and go from being a lender to an owner, you do have that right. You have that convertible right. Now you might be saying, why would the company do so? Why would the company sell a bond that gives you the right to convert? Well, guess what? When you sell a bond and the company have the right to convert the bond, the company will pay lower interest. In other words, they're giving you an additional feature. So the company don't have to pay high interest. So here what they pay is 4%. Maybe without the feature, they might have to pay 8% or 7%. So what they say, they say, we'll pay you 4% and you might tell them, this is too low. I'm not going to buy your bond. Well, I'm going to pay you 4% and I'm going to tell you this bond is convertible. Anytime you would like to convert it, you can convert it. Well, that's a good feature. Then I might accept the 4%. At the date of the issue, the interest rate for similar debt without conversion is 6%. There you go. So if the convertible feature did not exist, if the convertible feature did not exist for this bond, the company would have to pay 6% rather than 4%. Now we have to find, because we have both a debt and equity, we have to find how much of the bond is debt and how much of it is equity. Now, what do we do? Well, we know the bond should have a 6% interest rate. So what we're saying is the bond should earn interest rate at 6%. Then we have to find the fair value of the bond that we sold at 2 million. Well, if we sold the bond at 2 million, okay, we're going to have to find the price of the bond. To find the price of the bond, you have to discount the 2 million. You have to discount the principal and you have to discount the payment. Let me show you the computation. Okay, we're going to take the principal amount and this is how we find the price of the bond multiplied by the present value factor 0.7473. Five periods, interest rate equal to 6%. We use the interest rate that the market, that the interest rate for similar bond will paying. So the bond is worth, the face value of the bond is worth 1,494,516. Then we have to find the payment on that bond. The payment is 80,000. Why 80,000? Because the bond is 2 million dollar and paying 8% times with interest payable annually. I'm sorry, paying 4%, not 8% times 4%. So every year the bond pays 80,000. And this is going to be five payments. We're going to make five payments on this bond. Why? Because it's five years. Therefore, when we go to the present value and not the table, we use n equal to 5%. And we always use the market rate, 6%. Therefore, we discount the 80,000 at that factor. Therefore, the bond by itself. So remember, we have the bond and the call option, the bond by itself, the fair value of the liability is 1,831,015. This is the bond, the bond on its own, on its own. Let me go back to that example here. Let me go back to that example here and show you the picture. So what happened here, let me erase everything, then show you on the picture what does it look like. So we're saying, what we're saying is we receive 2 million for the whole thing. Then we determine the value of the bond. The value of the bond was 1,831,055 based on the present value of the principal, based on the present value of the payment. Now, if you don't know how to do this computation, well, you're going to have to go to my intermediate accounting bond computation, which is chapter 14 in my intermediate accounting, if you don't know how to do this. So what's left for the other section is 168,495. So this is 1,831,055 and the equity portion is worth 168,495. So we know the total and we know the bond. Sometimes we know the total and we can know the equity. Okay, good. Now we know the bond. Now let's take a look at the journal entry. The journal entry, the company will debit cash 2 million. They will credit bonds payable for 1,831,055 and the remainder will go to additional paid in capital. Now under US cap, the entry would look a little bit different because we might have a discount, we might have a premium, but this is basically just an idea to help you move on to understand the compound financial instrument. Okay, now if you have any issues with bond, any issues with bond, I really don't understand bond, especially if this was confusing to you. This computation here was confusing to you what I did here. Well, what I did here is confusing. Go to chapter 14, intermediate accounting. Okay, now, if you feel that those factors, where is this coming from, 0.7473, those are intimidating to me. I don't understand how it works. Then go to my intermediate accounting chapter 6. Chapter 6 talks about discusses the time value of money, which is I have three, four hours of lectures and examples. And if you don't know how the time value of money work, then you should not be in accounting. Okay, or you should not be studying accounting or you should go back to learn time value of money because we're going to see this concept in leases and pension and bonds and anything and everything. Okay, why? Because the time value of money is an important concept. If you have any questions about this recording, please email me if you happen to visit my website. Please consider donating to support the channel. If you're studying for your ACCA or CPA exam, study hard. It's worth it. Good luck and see you on the other side of success.