Financial instruments


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Financial instruments

  1. 1. Financial Instruments IAS 32 / 39 / IFRS 9
  2. 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. 3. DerivativesA derivative is a financial instrument or other contract with thefollowing 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. 4. Examples of Derivatives• Forward Contracts• Futures• Interest rate swaps• Options KAPP Edge Solutions
  5. 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. 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. 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. 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. 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 anotherentity under conditions that are potentially unfavourable to the entity;or(b) a contract that will or may be settled in the entity’s own equityinstruments and is:(i) a non-derivative for which the entity is or may be obliged to delivera variable number of the entity’s own equity instruments; or(ii) a derivative that will or may be settled other than by the exchangeof a fixed amount of cash or another financial asset for a fixed numberof the entity’s own equity instruments. KAPP Edge Solutions
  10. 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. 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. 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. 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. 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. 15. At fair valueIFRS 9 provides that changes in the value of a financial assetmeasured at fair value, but not held for trading purposes, may bedone through Other Comprehensive Income. However, thischoice has to be made by the entity at the time of initialrecognition of the asset. This decision is irrevocable, and cannotbe changed later. KAPP Edge Solutions
  16. 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. 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. 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. 19. Measurement of liability at fair valueK 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. 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. 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. 22. Classification Financial Instruments Financial Assets Financial liabilities At amortised costFV through FV through Other At fair value at amortised cost Income through income statement Comprehensive Income statement KAPP Edge Solutions
  23. 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. 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. 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. 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. 27. KAPP EDGE