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Financial Instruments

   IAS 32 / 39 / IFRS 9
Financial Instruments

• Discuss the definition and classification of a financial instrument
• Account for debt instruments, equity instruments and the allocation
  of finance costs
• Account for fixed interest rate and convertible bonds
• Discuss the measurement issues relating to financial instruments
• Explain the measurement requirements for financial instruments
  including the use of current values, hedging and the treatment of
  gains and losses
• Describe the nature of the presentation and disclosure requirements
  relating to financial instruments
• Discuss the key areas where consensus is required on the accounting
  treatment of financial instruments


                            KAPP Edge Solutions
Derivatives
A derivative is a financial instrument or other contract with the
following characteristics:

• Its value changes in response to an underlying;
• It requires no or little initial investment; and
• It is settled at a future date.




                           KAPP Edge Solutions
Examples of Derivatives
•   Forward Contracts
•   Futures
•   Interest rate swaps
•   Options




                          KAPP Edge Solutions
Definition of Financial Instruments

• A financial instrument is a contract which results in a financial
  asset for one entity and a financial liability or equity
  instrument for another entity.

• K Ltd invests in debentures of T Ltd.
• K Ltd invests in shares of T Ltd.




                            KAPP Edge Solutions
Financial Assets
• Cash;
• An equity instrument of another entity.
• A contractual right to receive cash or another financial asset
  from another entity.
• A contractual right to exchange financial assets or financial
  liabilities with another entity under conditions that is
  potentially favourable to the entity;




                            KAPP Edge Solutions
Example
•   K Ltd, an Indian company, exports goods to US. It expects to receive
    $100,000 in 3 months’ time from these sales. However, it is concerned that
    the USD prices against local currency (INR) may fall, and therefore, it will
    be at a loss. To safeguard itself, K Ltd enters into a contract with a bank to
    sell $100,000 (that it expects to receive) in 3 months’ time. The rate agreed
    with the bank is INR 50 per USD.
•   After 3 months, if the exchange rate (spot rate) is less than INR 50 per
    USD, this means that the conditions are potentially favourable to K Ltd. In
    other words, had K Ltd not entered into this contract, it would have sold
    USD 100,000 at a lesser rate for conversion into INR. Hence, the contract
    is potentially favourable to K Ltd, and therefore, a financial asset




                                  KAPP Edge Solutions
Definition of financial asset….continued
•   A contract that will or may be settled in the entity’s own equity instruments
    and is:

•   a non-derivative for which an entity is or may be obliged to receive a variable number of
    its own equity instruments; or
      – K Ltd enters into a contract to buy its own shares for $1 million in 3 months’ time, and
         the number of shares is determined by the market price prevailing then.

•   a derivative that will or may be settled other than by exchange of a fixed amount of cash
    or another financial asset for a fixed number of entity’s own equity instruments.
•   K Ltd enters into a contract to buy 1,000 shares of its own by exchange of 500 gm of gold
    after 3 months’. The current price of 500 gm gold equals 1,000 shares of K Ltd. Assuming
    that the price of gold decreases after 3 months time as compared to the proportion between
    gold and shares initially, K Ltd is better off by exchanging the gold against the 1,000 shares.
    In this case, the contract would be an example of a financial asset.



                                         KAPP Edge Solutions
Definition of financial liability
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
 (ii) to exchange financial assets or financial liabilities with another
entity under conditions that are potentially unfavourable to the entity;
or

(b) a contract that will or may be settled in the entity’s own equity
instruments and is:
(i) a non-derivative for which the entity is or may be obliged to deliver
a variable number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange
of a fixed amount of cash or another financial asset for a fixed number
of the entity’s own equity instruments.



                               KAPP Edge Solutions
Items excluded from financial assets
•   Physical assets / Intangible assets
•   Pre-paid expenses
•   Deferred tax assets
•   Items covered under other accounting standards including:

    –   Interests in subsidiaries;
    –   Interests in associates;
    –   Employee benefits plans;
    –   Interests in joint ventures;


                               KAPP Edge Solutions
Classification of financial assets under IFRS 9

(A) At amortised cost:
 An asset (other than equity instrument) that meets the below mentioned
   conditions:
 The asset is held within a business model whose objective is to hold assets
   in order to collect contractual cash flows;
 The contractual cash terms of the financial asset give rise to cash flows on
   specific dates that are solely payments of principal and interest on the
   principal amount outstanding;
 The entity has not invoked the fair value option for measurement of
   financial asset to reduce an accounting or measurement mismatch

(B) At fair value


                                 KAPP Edge Solutions
Business Model
• An entity’s business model approach is determined on a higher
  level, rather than an asset-by-asset basis. Further, the entity
  may have different assets (portfolio of assets) for business
  purposes.
• Accordingly, it may not be right to identify the business model
  on an entity’s level either. The entity may comprise of a
  portfolio of assets which is collected on the basis of
  contractual cash flows, and of a portfolio of assets in which it
  trades.




                           KAPP Edge Solutions
Examples
•   K Ltd, a banking company, issues loans to various customers in retail
    business. A customer, having taken a 20 years loan, decides to pay off the
    loan in 5 years’ time. K Ltd cannot refuse the pre-payment, and would
    receive the money due from the customer.

•   K Ltd gives loan to various clients in the retail sector. If someone does not
    pay the instalment, K Ltd would follow different measures to recover
    money. It may further mean to recover money by selling off the collateral.

•   K Ltd, a mutual fund company, has invested in different portfolios and
    sectors. It works with an objective of keeping a ratio of 60:40 into debt and
    equity.



                                   KAPP Edge Solutions
Amortised cost

• K Ltd invests $100,000 into debt instrument of T Ltd. The cost
  of advisory / valuation comes at $5,000. K Ltd’s business
  model is to collect contractual cash flows in form of recovery
  of interest and principal payments.




                          KAPP Edge Solutions
At fair value

IFRS 9 provides that changes in the value of a financial asset
measured at fair value, but not held for trading purposes, may be
done through Other Comprehensive Income. However, this
choice has to be made by the entity at the time of initial
recognition of the asset. This decision is irrevocable, and cannot
be changed later.




                            KAPP Edge Solutions
Examples
•   K Ltd invests in 3 years’ redeemable preference shares of T Ltd. K Ltd holds these
    shares until maturity and recovers the cash flows through dividend and principal
    repayment.
•   K Ltd invests in bonds of T Ltd. The intention is to hold these bonds for a longer
    term. However, K Ltd decided to value the investment at fair value routed through
    profit and loss.
•   K Ltd has receivables of $5 million from T Ltd. The business model of K Ltd is to
    sell off the receivables portfolio to 3rd party and recover money the moment sales
    are made.
•   K Ltd has invested in debentures of T Ltd. K Ltd has an intention to hold these
    debentures until maturity. However, if K Ltd identifies a substantial gain, it may sell
    off the debentures to realise the gain.

•   A perpetual debt (with no maturity) is considered at amortised cost.
•   A debt instrument convertible into equity shares of the entity is considered at fair
    value, rather than at amortised cost. The recovery is not necessarily coming through
    contractual cash flows in form of principal and interest.



                                      KAPP Edge Solutions
At fair value

• K Ltd invests $100,000 into shares of T Ltd (not for trading
  purposes). The cost of advisory / valuation comes at $5,000.




                           KAPP Edge Solutions
Classification of financial liabilities
•   Classification of Financial liabilities

•   Under the principles of IAS 39, a financial asset may be classified under
    two categories:

•   At amortised cost:
•   An entity shall classify all financial liabilities as subsequently measured at
    amortised cost using the effective rate of interest method, unless the
    financial liability is measured at fair value through profit or loss.

•   At fair value through profit or loss:
•   The classification into fair value through profit or loss is applicable if:
•   The classification reduces the accounting mismatch; or
•   The liability is managed and its performance is evaluated on a fair value
    basis as per the documented investment strategy or risk management.

                                   KAPP Edge Solutions
Measurement of liability at fair value


K Ltd issues $100,000 debt instrument. The cost of advisory /
valuation comes at $5,000. K Ltd’s trades in this liability.




                           KAPP Edge Solutions
Costs directly related to issuance of equity
                      and debt
•   Transaction costs are the incremental costs directly attributable to the
    acquisition, issue or disposal of a financial asset or liability. These include:
     – Legal fee (Stock exchange listing fee);
     – Advisory fees;
     – Printing and stamp charges;

•   Transaction costs directly attributable to equity issuance, that otherwise
    would have been avoided, are deducted from equity.
•   Similarly, transaction costs directly attributable to debt issuance, that
    otherwise would have been avoided, are deducted from debt to arrive at
    its initial value.




                                   KAPP Edge Solutions
Directly attributable costs
• K Ltd has issued 1 million shares of $1 each. The total
  proceeds of issuance of shares are $1.2 million. Total costs of
  printing of these shares and advisory costs are $100,000.
• K Ltd plans to issue 1 million shares of $1 each. However, of
  these shares, 200,000 shares have not been issued. Total cost
  of printing of 1 million shares in physical form is $100,000.




                           KAPP Edge Solutions
Classification
                                            Financial
                                           Instruments




             Financial Assets                                   Financial
                                                                liabilities



                                    At amortised
                                        cost



FV through         FV through
                      Other                             At fair value         at amortised cost
  Income                                              through income
 statement        Comprehensive
                     Income                              statement




                                KAPP Edge Solutions
Initial measurement of financial assets
               and liabilities
 For financial assets:

• A financial asset is measured at its fair value (for a financial
  asset recognised / classified at fair value);

• A financial asset is measured at its fair value plus attributable
  transaction costs (for a financial asset recognised / classified at
  amortised cost)




                            KAPP Edge Solutions
Amortised cost concept
• On 1st January 2011, K Ltd invested in bonds of T Ltd worth
  $500,000. It pays transaction costs (directly attributable to
  acquisition of the bonds) of $20,000 to invest into these bonds.
  At the end of each year, K Ltd received interest @ 6% on the
  principal amount of $500,000. The effective interest rate is
  9.15%. At the end of 4 years, K Ltd receives $600,000 as
  redemption amount.




                           KAPP Edge Solutions
Compound Instruments

• Comprise of both equity and liability
• Liability portion has to be separately calculated
• Equity is the residual balance (remaining amount)




                          KAPP Edge Solutions
Compound Instruments
•   On 1 April 2010 Alpha issued 300 million loan notes of $1 per note at par.
    The loan notes entitled the holders to an interest payment of 5 cents per
    note, payable annually in arrears. The loan notes are repayable at par on 31
    March 2015. As an alternative to repayment the holders can elect to convert
    the notes into equity shares in Alpha. On 1 April 2010 investors in non-
    convertible notes would expect an annual return of 8%. You are given the
    following discount factors:
•   Discount rate                     PV of $1
                   At the end of year 5             Cumulatively at the end of years 1–5
•   5%                       78·4 cents                                $4·33
•   8%                       68·1 cents                                $3·99

•   On 1 April 2010 the directors of Alpha recorded a loan liability of $300
    million in respect of these notes. Identify the liability and equity amount as
    at 31st March 2011 in respect of above note.



                                   KAPP Edge Solutions
KAPP EDGE Solutions
www.onlineglobalcareer.com
  mail-info@onlineglobalcareer.com

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Financial instruments

  • 1. Financial Instruments IAS 32 / 39 / IFRS 9
  • 2. Financial Instruments • Discuss the definition and classification of a financial instrument • Account for debt instruments, equity instruments and the allocation of finance costs • Account for fixed interest rate and convertible bonds • Discuss the measurement issues relating to financial instruments • Explain the measurement requirements for financial instruments including the use of current values, hedging and the treatment of gains and losses • Describe the nature of the presentation and disclosure requirements relating to financial instruments • Discuss the key areas where consensus is required on the accounting treatment of financial instruments KAPP Edge Solutions
  • 3. Derivatives A derivative is a financial instrument or other contract with the following characteristics: • Its value changes in response to an underlying; • It requires no or little initial investment; and • It is settled at a future date. KAPP Edge Solutions
  • 4. Examples of Derivatives • Forward Contracts • Futures • Interest rate swaps • Options KAPP Edge Solutions
  • 5. Definition of Financial Instruments • A financial instrument is a contract which results in a financial asset for one entity and a financial liability or equity instrument for another entity. • K Ltd invests in debentures of T Ltd. • K Ltd invests in shares of T Ltd. KAPP Edge Solutions
  • 6. Financial Assets • Cash; • An equity instrument of another entity. • A contractual right to receive cash or another financial asset from another entity. • A contractual right to exchange financial assets or financial liabilities with another entity under conditions that is potentially favourable to the entity; KAPP Edge Solutions
  • 7. Example • K Ltd, an Indian company, exports goods to US. It expects to receive $100,000 in 3 months’ time from these sales. However, it is concerned that the USD prices against local currency (INR) may fall, and therefore, it will be at a loss. To safeguard itself, K Ltd enters into a contract with a bank to sell $100,000 (that it expects to receive) in 3 months’ time. The rate agreed with the bank is INR 50 per USD. • After 3 months, if the exchange rate (spot rate) is less than INR 50 per USD, this means that the conditions are potentially favourable to K Ltd. In other words, had K Ltd not entered into this contract, it would have sold USD 100,000 at a lesser rate for conversion into INR. Hence, the contract is potentially favourable to K Ltd, and therefore, a financial asset KAPP Edge Solutions
  • 8. Definition of financial asset….continued • A contract that will or may be settled in the entity’s own equity instruments and is: • a non-derivative for which an entity is or may be obliged to receive a variable number of its own equity instruments; or – K Ltd enters into a contract to buy its own shares for $1 million in 3 months’ time, and the number of shares is determined by the market price prevailing then. • a derivative that will or may be settled other than by exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments. • K Ltd enters into a contract to buy 1,000 shares of its own by exchange of 500 gm of gold after 3 months’. The current price of 500 gm gold equals 1,000 shares of K Ltd. Assuming that the price of gold decreases after 3 months time as compared to the proportion between gold and shares initially, K Ltd is better off by exchanging the gold against the 1,000 shares. In this case, the contract would be an example of a financial asset. KAPP Edge Solutions
  • 9. Definition of financial liability (a) a contractual obligation: (i) to deliver cash or another financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or (b) a contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. KAPP Edge Solutions
  • 10. Items excluded from financial assets • Physical assets / Intangible assets • Pre-paid expenses • Deferred tax assets • Items covered under other accounting standards including: – Interests in subsidiaries; – Interests in associates; – Employee benefits plans; – Interests in joint ventures; KAPP Edge Solutions
  • 11. Classification of financial assets under IFRS 9 (A) At amortised cost:  An asset (other than equity instrument) that meets the below mentioned conditions:  The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows;  The contractual cash terms of the financial asset give rise to cash flows on specific dates that are solely payments of principal and interest on the principal amount outstanding;  The entity has not invoked the fair value option for measurement of financial asset to reduce an accounting or measurement mismatch (B) At fair value KAPP Edge Solutions
  • 12. Business Model • An entity’s business model approach is determined on a higher level, rather than an asset-by-asset basis. Further, the entity may have different assets (portfolio of assets) for business purposes. • Accordingly, it may not be right to identify the business model on an entity’s level either. The entity may comprise of a portfolio of assets which is collected on the basis of contractual cash flows, and of a portfolio of assets in which it trades. KAPP Edge Solutions
  • 13. Examples • K Ltd, a banking company, issues loans to various customers in retail business. A customer, having taken a 20 years loan, decides to pay off the loan in 5 years’ time. K Ltd cannot refuse the pre-payment, and would receive the money due from the customer. • K Ltd gives loan to various clients in the retail sector. If someone does not pay the instalment, K Ltd would follow different measures to recover money. It may further mean to recover money by selling off the collateral. • K Ltd, a mutual fund company, has invested in different portfolios and sectors. It works with an objective of keeping a ratio of 60:40 into debt and equity. KAPP Edge Solutions
  • 14. Amortised cost • K Ltd invests $100,000 into debt instrument of T Ltd. The cost of advisory / valuation comes at $5,000. K Ltd’s business model is to collect contractual cash flows in form of recovery of interest and principal payments. KAPP Edge Solutions
  • 15. At fair value IFRS 9 provides that changes in the value of a financial asset measured at fair value, but not held for trading purposes, may be done through Other Comprehensive Income. However, this choice has to be made by the entity at the time of initial recognition of the asset. This decision is irrevocable, and cannot be changed later. KAPP Edge Solutions
  • 16. Examples • K Ltd invests in 3 years’ redeemable preference shares of T Ltd. K Ltd holds these shares until maturity and recovers the cash flows through dividend and principal repayment. • K Ltd invests in bonds of T Ltd. The intention is to hold these bonds for a longer term. However, K Ltd decided to value the investment at fair value routed through profit and loss. • K Ltd has receivables of $5 million from T Ltd. The business model of K Ltd is to sell off the receivables portfolio to 3rd party and recover money the moment sales are made. • K Ltd has invested in debentures of T Ltd. K Ltd has an intention to hold these debentures until maturity. However, if K Ltd identifies a substantial gain, it may sell off the debentures to realise the gain. • A perpetual debt (with no maturity) is considered at amortised cost. • A debt instrument convertible into equity shares of the entity is considered at fair value, rather than at amortised cost. The recovery is not necessarily coming through contractual cash flows in form of principal and interest. KAPP Edge Solutions
  • 17. At fair value • K Ltd invests $100,000 into shares of T Ltd (not for trading purposes). The cost of advisory / valuation comes at $5,000. KAPP Edge Solutions
  • 18. Classification of financial liabilities • Classification of Financial liabilities • Under the principles of IAS 39, a financial asset may be classified under two categories: • At amortised cost: • An entity shall classify all financial liabilities as subsequently measured at amortised cost using the effective rate of interest method, unless the financial liability is measured at fair value through profit or loss. • At fair value through profit or loss: • The classification into fair value through profit or loss is applicable if: • The classification reduces the accounting mismatch; or • The liability is managed and its performance is evaluated on a fair value basis as per the documented investment strategy or risk management. KAPP Edge Solutions
  • 19. Measurement of liability at fair value K Ltd issues $100,000 debt instrument. The cost of advisory / valuation comes at $5,000. K Ltd’s trades in this liability. KAPP Edge Solutions
  • 20. Costs directly related to issuance of equity and debt • Transaction costs are the incremental costs directly attributable to the acquisition, issue or disposal of a financial asset or liability. These include: – Legal fee (Stock exchange listing fee); – Advisory fees; – Printing and stamp charges; • Transaction costs directly attributable to equity issuance, that otherwise would have been avoided, are deducted from equity. • Similarly, transaction costs directly attributable to debt issuance, that otherwise would have been avoided, are deducted from debt to arrive at its initial value. KAPP Edge Solutions
  • 21. Directly attributable costs • K Ltd has issued 1 million shares of $1 each. The total proceeds of issuance of shares are $1.2 million. Total costs of printing of these shares and advisory costs are $100,000. • K Ltd plans to issue 1 million shares of $1 each. However, of these shares, 200,000 shares have not been issued. Total cost of printing of 1 million shares in physical form is $100,000. KAPP Edge Solutions
  • 22. Classification Financial Instruments Financial Assets Financial liabilities At amortised cost FV through FV through Other At fair value at amortised cost Income through income statement Comprehensive Income statement KAPP Edge Solutions
  • 23. Initial measurement of financial assets and liabilities For financial assets: • A financial asset is measured at its fair value (for a financial asset recognised / classified at fair value); • A financial asset is measured at its fair value plus attributable transaction costs (for a financial asset recognised / classified at amortised cost) KAPP Edge Solutions
  • 24. Amortised cost concept • On 1st January 2011, K Ltd invested in bonds of T Ltd worth $500,000. It pays transaction costs (directly attributable to acquisition of the bonds) of $20,000 to invest into these bonds. At the end of each year, K Ltd received interest @ 6% on the principal amount of $500,000. The effective interest rate is 9.15%. At the end of 4 years, K Ltd receives $600,000 as redemption amount. KAPP Edge Solutions
  • 25. Compound Instruments • Comprise of both equity and liability • Liability portion has to be separately calculated • Equity is the residual balance (remaining amount) KAPP Edge Solutions
  • 26. Compound Instruments • On 1 April 2010 Alpha issued 300 million loan notes of $1 per note at par. The loan notes entitled the holders to an interest payment of 5 cents per note, payable annually in arrears. The loan notes are repayable at par on 31 March 2015. As an alternative to repayment the holders can elect to convert the notes into equity shares in Alpha. On 1 April 2010 investors in non- convertible notes would expect an annual return of 8%. You are given the following discount factors: • Discount rate PV of $1 At the end of year 5 Cumulatively at the end of years 1–5 • 5% 78·4 cents $4·33 • 8% 68·1 cents $3·99 • On 1 April 2010 the directors of Alpha recorded a loan liability of $300 million in respect of these notes. Identify the liability and equity amount as at 31st March 2011 in respect of above note. KAPP Edge Solutions
  • 27. KAPP EDGE Solutions www.onlineglobalcareer.com mail-info@onlineglobalcareer.com