A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity of another. This includes cash, loans, bonds, receivables, and payables.

• Classification of Financial Assets: IPSAS 41 requires classification into one of three measurement categories:
  1. Amortized Cost: Used for assets held to collect contractual cash flows (e.g., loans, bonds held to maturity).
  2. Fair Value through Net Assets/Equity (FVNAE): Used for assets where the objective is both collecting cash flows and selling the asset. Unrealized gains/losses go to a reserve in equity.
  3. Fair Value through Surplus or Deficit (FVTSD): The default category, used for assets like equity investments (shares) or those held for trading. Unrealized gains/losses go directly to the surplus/deficit.
• Impairment: Expected Credit Loss (ECL) Model
• • IPSAS 41 introduced a forward-looking impairment model.
  • Entities must recognize a loss allowance for expected future credit losses, rather than waiting for an actual default to occur (the old “incurred loss” model).
  • This requires recognizing a provision for 12-month ECL on initial recognition, which moves to lifetime ECL if the asset’s credit risk increases significantly.

Example: Financial Asset at Amortized Cost (IPSAS 41)

On July 1, 2020, the County Treasury of XYZ purchased 10% loan notes with a nominal value of Ksh 60,000,000 at a 5% discount. The County incurred transaction costs of Ksh 1,000,000.

Additional Terms:

• Interest is paid annually in arrears, based on the nominal value.
• The notes will be redeemed at par (Ksh 60,000,000) on June 30, 2025.
• The effective interest rate (EIR) is 11% per annum.
• The investment is classified as measured at amortized cost under IPSAS 41, as the County’s business model is to hold the asset to collect its contractual cash flows (principal and interest).

Step 1: Classification and Initial Measurement

Classification: The loan notes are classified as measured at Amortized Cost because they meet two criteria under IPSAS 41:

1. Business Model Test: The County’s objective is to hold the asset to collect its contractual cash flows.
2. Cash Flow Characteristics Test (SPPI): The contractual cash flows represent solely payments of principal and interest on the principal amount outstanding.

Initial Measurement: The asset is initially measured at its fair value plus directly attributable transaction costs.

• Nominal Value: Ksh 60,000,000
• Less: 5% Discount: (Ksh 3,000,000)
• Purchase Price (Fair Value): Ksh 57,000,000
• Add: Transaction Costs: Ksh 1,000,000
• Initial Carrying Amount: Ksh 58,000,000

Journal Entry (July 1, 2020):

• Dr Financial Asset (Loan Notes) Ksh 58,000,000
• Cr Cash/Bank Ksh 58,000,000 (To record the acquisition of the loan notes)

Step 2: Amortization Schedule (Using the Effective Interest Method)

An amortization schedule is prepared to track the interest income, cash received, and the carrying amount of the asset over its life.

Note: The interest income for the final year is a balancing figure to ensure the closing balance equals the redemption value of Ksh 60,000,000.

Step 3: Annual Accounting Treatment and Journal Entries

Each year, the County Treasury recognizes the interest income based on the effective interest rate, not the coupon rate.

Example Journal Entry (for the year ended June 30, 2021):

• Dr Cash/Bank Ksh 6,000,000
• Dr Financial Asset (Loan Notes) Ksh 380,000
• Cr Interest Income (Surplus/Deficit) Ksh 6,380,000 (To record interest income earned and cash received for the year)

This entry is repeated each year using the corresponding figures from the amortization schedule.

Step 4: Derecognition at Maturity (June 30, 2025)

On the redemption date, the County receives the principal amount and derecognizes the financial asset.

Journal Entry (June 30, 2025):

• Dr Cash/Bank Ksh 60,000,000
• Cr Financial Asset (Loan Notes) Ksh 60,000,000 (To record the redemption of the loan notes at par)