Financial Instruments 1 (training)

8/10/2019 Financial Instruments 1 (training)

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FINANCIAL INSTRUMENTS 1: INTRODUCTIONTO FINANCIAL INSTRUMENTS

Lesson 2: Overview

Standards applicable to financial instruments

International Accounting Standard 32 (IAS 32), IAS 39 andInternational Financial Reporting Standard 7 (IFRS 7) comprise theaccounting and disclosure requirements for financial instrumentsunder IFRS.

IAS 32 Financial Instruments: PresentationIAS 32 provides rules over the presentation of financial instruments asliabilities or equity and for offsetting financial assets and liabilities.

IAS 32 is effective for annual periods beginning on or after 1 January2005.

IAS 39 Financial Instruments: Recognition and Measurement

IAS 39 outlines the requirements over financial instruments and somecontracts to buy or sell non-financial items for: Recognition and de-recognition Initial and subsequent measurement Hedge accounting

IAS 39 is effective for annual periods beginning on or after 1 January2005.

IFRS 7 Financial Instruments: DisclosuresIFRS 7 requires disclosure of information about the significance offinancial instruments to a reporting entity. IFRS 7 is covered in aseparate web-based learning.

IFRS 7 is effective for annual periods beginning on or after 1 January2007.

Definitions

There are a number of terms which you should understand before youstart studying financial instruments in depth:

Financial instrument A financial instrument is any contract that gives rise to a financialasset of one entity and a financial liability or equity instrument ofanother entity.

Financial asset A financial asset is any asset that is:

(a) Cash(b) An equity instrument of another entity(c) A contractual right:

(i) To receive cash or another financial asset from anotherentity; or

(ii) To exchange financial assets or financial liabilities withanother entity under conditions that are potentiallyfavorable to the entity; or

(d) A contract that will or may be settled in the entitys own equityinstruments and is:

(i) A non-derivative for which the entity is or may be obliged toreceive a variablenumber of the entitys own equityinstruments; or

asset for a fixed number of the entitys own equityinstruments subject to certain exclusions within IAS

What is not a financial asset? Physical assets for example, inventories, property, plant andequipment, commodities (such as gold bullion), leased assets anintangible assets (such as servicing rights) are not financial assetControl of such physical and intangible assets creates an opportuto generate an inflow of cash or another financial asset, but it do

give rise to a present right to receive cash or another financial asLikewise, assets, such as prepaid expenses for which the futureeconomic benefit is the receipt of goods or services, are not finaassets

Financial liability A financial liability is any liability that is:

(a) A contractual obligation:(i) To deliver cash or another financial asset to another e

or(ii) To exchange financial assets or financial liabilities w

another entity under conditions that are potentiallyunfavorable

to the entity; or(b) A contract that will or may be settled in the entitys own equitinstruments and is:

(i) A non-derivative for which the entity is or may be obdeliver a variable number of the entitys own equityinstruments; or

(ii) A derivative that will or may be settled other than byexchange of a fixed amount of cash or another financasset for a fixed number of the entitys own equityinstruments. For this purpose the entitys own equityinstruments do not include instruments that arethemselves contracts for the future receipt or deliverythe entitys own equity instruments subject to certain

exclusions within IAS 32.

What is not a financial liability? A current tax payable, for example, is not considered a financialliability. Income taxes are the result of statutory requirements imby governments and are not considered contractual obligations.Similarly, constructive obligations do not arise from contracts antherefore, are not financial liabilities.

Other DefinitionsThere are additional definitions you should understand before yostart studying more about financial instruments.

Equity Instrument An equity instrument is any contract that evidences a residual inin the assets of an entity after deducting all of its liabilities.

Examples of equity instruments include common (ordinary) sharthe entity cannot be required to redeem, some types of preferencshares and warrants or written call options that allow the holder subscribe for the purchase of a fixed number of ordinary shares issuing entity in exchange for a fixed amount of cash or another

financial asset.

Fair Value


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an orderly transaction between market participants at themeasurement date.

Derivative A derivative is a financial instrument or other contract within the scopeof IAS 39 with all three of the following characteristics:

(a) Its value changes in response to the change in a specifiedinterest rate, financial instrument price, commodity price, foreignexchange rate, index of prices or rates, credit rating or credit

index, or other variable, provided in the case of a non-financialvariable that the variable is not specific to a party to the contract(sometimes called theunderlying);

(b) It requires no initial net investment or an initial net investmentthat is smaller than would be required for other types ofcontracts that would be expected to have a similar response tochanges in market factors; and

(c) It is settled at a future date.

Embedded Derivative An embedded derivative is a component of a hybrid (combined)instrument that also includes a non-derivative host contract with theeffect that some of the cash flows of the combined instrument vary in a

way similar to a stand-alone derivative. An embedded derivativecauses some or all of the cash flows that otherwise would be requiredby the contract to be modified according to a specified interest rate,financial instrument price, commodity price, foreign exchange rate,index of prices or rates, credit rating or credit index, or other variable,provided in the case of a non-financial variable that the variable is notspecific to a party to the contract. A derivative that is attached to afinancial instrument but is contractually transferable independently ofthat instrument, or has a different counterparty from that instrument, isnot an embedded derivative but a separate financial instrument.

An example of an embedded derivative is interestpayments on a host debt instrument indexed to

movements in the FTSE 100.

DerecognitionDerecognition is the removal of a previously recognized financial assetor financial liability from an entitys statement of financial position. IAS39 contains detailed rules for the derecognition of financial assets andfinancial liabilities.

Derecognition of financial assets and financial liabilities is veryimportant to entities as it may substantially affect their statement offinancial position and, therefore, have an impact on different ratios andwhether or not debt covenants are met.

Types of financial instrumentsThe following items are different types of financial instruments.

CashCash is described in IAS 7Statement of Cash Flows ascomprising cash on hand and demand deposits. Thepurpose of cash is to pay off short term liabilities of theentity. IAS 32 explains that cash is a financial assetbecause it represents the medium of exchange and is,therefore, the basis on which all transactions aremeasured and recognised in financial statements. Adeposit of cash with a bank or similar financial institutionis a financial asset because it represents the contractualright of the depositor to obtain cash from the institution orto draw a cheque or similar instrument against the

Certificate of deposit A certificate of deposit (CD) is a savingscertificateentitling the bearer to receive interest. A CD bears amaturity date and a specified interest rate and can beissued in any denomination. CDs are generally issuedcommercial banks. Technically, a certificate of depospromissory note on which the borrower is a bank.

Commercial paperCommercial paper is an unsecured, short-term corpoobligation usually issued at a discount from face valuBecause most commercial paper is unsecured, it isusually issued by entities with investment-grade credratings.

Convertible debtConvertible debt is a debt instrument which can beconverted, at a specified price, into equity of the issuThe conversion is at the holders option, and in mostcases, convertible securities are callable at a premiumthe issuers option, beginning a few years after issuan

Investors usually receive a lower coupon rate but theinstrument carries additional value through the optioconvert the debt to equity and thereby participating ifurther growth in the entitys equity value.

Preferred sharesPreferred shares usually provide a specific dividend is paid before any dividends are paid to ordinaryshareholders. The dividend rights are often cumulativsuch that if the dividend is not paid, it accumulates fryear to year. Preferred shares usually carry no votingrights but they take priority over ordinary shares in thevent of liquidation. In certain cases, preferred sharemay have a convertibility feature into ordinary share

Financial instruments include a number of types of assets.

Medium-term noteMedium-term notes are debt instruments with maturiranging between 5 to 10 years. Medium-term notesprovide the issuer with flexibility in raising cash by, effect, arranging for long-term financing at short-termrates.

Zero coupon bond A zero coupon debt instrument is a bond with no perinterest payments (that is, coupons), issued at asubstantial discount from face value. The holder of subond receives a return by the gradual appreciation ofbond, which is redeemed at face value at maturity.Issuers have the ability to raise cash without makingcurrent payments on the bond and these are often useleveraged buyouts where cash flows in the early yearmay be critical.

Question 1Which of the following is not a financial asset?A. Intangible assetB. Trade receivableC. DerivativeD. Cash


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A financial instrument is a _________ that gives rise to both a financial _________ in one entity and a financial _________ or equityinstrument in another entity.A. liability, contract, assetB. debt, contract, assetC. contract, asset, liabilityD. gain, asset, liability

Question 3

True or false: IFRS 7 provides rules relating to the presentation offinancial instruments.

The statement is false. IFRS 7 provides the rules relating to the disclosure offinancial instruments. IAS 32 is the Standard that provides the rules relating tothe presentation of financial instruments.

Question 4Which of the following is not a financial instrument?A. Finance leasesB. Trade receivablesC. DerivativesD. Tax liabilities

A tax liability does not meet the definition of a financial instrument as it is astatutory obligation imposed by governments rather than a contractualobligation. Leases in most cases meet the definition of a financial instrument,although they can sometimes be out of scope. In general, a finance lease i sregarded as a financial instrument, and an operating lease is not regarded asa financial instrument. Trade receivables and derivatives are two other formsof financial instruments.

Lesson 3: Scope of IAS 32 and IAS 39

Introduction

IAS 32 and IAS 39 apply to all types of financial instruments, subjectto certain scope exclusions. IFRS 7Financial Instruments: Disclosure is covered in a separate web-based learning. Hence this lesson willconcentrate only on the scope exclusions of IAS 32 and IAS 39.

Subsidiaries, associates, and joint venturesInterests in subsidiaries, associates, and joint ventures that areaccounted for under IFRS 10Consolidated Financial Statements, IAS27 Separate Financial Statements, IAS 28 Investments in Associatesand Joint Ventures, unless such Standards require the interest to beaccounted for under IAS 39. Derivatives on the above interests wouldalso be accounted for under IAS 39 regardless of how the investment

is accounted for, unless the derivative meets the definition of an equityinstrument of the entity under IAS 32.

LeasesRights and obligations under leases to which IAS 17Leases appliesare not within the scope of IAS 32 but are within the scope of IAS 39only to the following extent:

Lease receivables and lease payables are subject to thederecognition provisions in IAS 39.

Lease receivables are subject to the impairment provisionsin IAS 39.

Derivatives embedded within lease contracts are subject tothe embedded derivatives rules within IAS 39.

Employee benefit plansEmployers rights and obligations under employee benefit plans to

Business combinationsForward contracts between an acquirer and a selling shareholderbuy or sell an acquiree that will result in a business combinationthe scope of IFRS 3Business Combinations at a future acquisitiondate. The term of the forward contract should not exceed a reasoperiod normally necessary to obtain any required approvals and complete the transaction.

Share-based payments

Financial instruments, contracts and obligations under share-baspayment transactions to which IFRS 2Share-based Payment applies.

IAS 37 exceptionsRights to payments to reimburse an entity for an expenditure it irequired to make to settle a liability recognized under IAS 37Provisions, Contingent Liabilities and Contingent Assets.

Equity instruments issued by the entityFinancial instruments issued by the entity that meet the definitioequity instrument in IAS 32 or that are required to be classified equity instrument under IAS 32 are not within the scope of IAS

Insurance contractsRights and obligations under insurance contracts as defined by IInsurance Contractsare excluded from the scope of IAS 32 and IA39. However, derivatives that are embedded in insurance contraare within the scope of IAS 39 unless the embedded derivative ian insurance contract under IFRS 4. IFRS 4 defines an insurancecontract as a contract under which one party accepts significainsurance risk from another party by agreeing to compensate thepolicyholder if a specified uncertain future event adversely affecpolicyholder. The scope exclusion applies to contracts that reimfor a loss actually incurred.

Financial guarantees

An issuers rights and obligations arising under an insurance contrare also in the scope of IAS 39 where they meet the definition ofinancial guarantee contract. However, if an issuer of financialguarantee contracts has previously asserted explicitly that it regasuch contracts as insurance contracts and has used accountingapplicable to insurance contracts, the issuer may elect to apply eIAS 39 or IFRS 4 to such financial guarantee contracts. The issumay make that election contract by contract, but the election forcontract is irrevocable. IAS 39 defines a financial guarantee conas a contract that requires the issuer to make specified paymenreimburse the holder for a loss it incurs because a specified debtfails to make payment when due in accordance with the originalmodified terms of a debt instrument.

Loan commitmentsLoan commitments are accounted for in accordance with IAS 37unless (a) the entity has a past practice of selling assets resultingloan commitments shortly after origination or (b) the commitme

Can be settled net (in cash or by some other financialinstrument)

Is issued at below-market interest rates Is designated at fair value through profit or loss

If it meets one of these criteria, the loan commitment is within thscope of IAS 39.

A loan commitment is a firm commitment to provide credit undespecified terms and conditions.


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Non-financial itemsNon-financial items normally are excluded from the scope of both IAS32 and 39. However, these Standards do apply to contracts to buy orsell non-financial items that can be settled net in cash or anotherfinancial instrument, or by exchanging financial instruments. Suchcontracts are treated as if they were financial instruments, unless thecontracts are entered into and continue to be held for the purpose ofthe receipt or delivery of a non-financial item in accordance with the

entitys expected purchase, sale or usage requirements (often referredto as the own use exception).

Scope exemption examples

Examples of the application of the scope exemptions are the following: Insurance contracts: a Japanese subsidiary of Market Co

enters into an insurance policy with Insure Co to coverlosses in the event of an earthquake in Japan. Insure Co isonly liable in case its customer (the Japanese subsidiary)incurs a loss due to an earthquake. This loss is consideredan identifiable insurable event and therefore is not within thescope of IAS 32 or 39.

Financial guarantee contracts: Ms. White is going to loanMr. Smith 100,000. Ms. White wants a credit guarantee froma bank as collateral for the loan. CMC Bank, Mr. Smithsbank, issues such a guarantee in favor of Ms. White for theloan. CMC Bank will only pay the loss incurred by Ms. Whitebecause Mr. Smith does not repay his debt. The creditguarantee meets the definition of a financial guaranteecontract, therefore it falls within the scope of IAS 39 fromCMC Banks perspective. The Bank may account for thecredit guarantee under IFRS 4 if it previously assertedexplicitly that it regards such contracts as insurancecontracts.

'Regular-way' security transactions: a regular waysecurity transaction is a transaction to purchase or sell asecurity under a contract whose terms require delivery of thesecurity within the time period that is customary for theexchange in which the trade occurred. A regular waypurchase or sale of financial assets is recognized usingeither trade date accounting or settlement date accounting.

Trade date and settlement date accounting: When tradedate accounting is applied, an entity recognizes an asset atthe trade date. When settlement date accounting is applied,an entity does not recognize an asset at the trade date, butinstead accounts for any change in the fair value of theasset to be received during the period between the tradedate and the settlement date in the same way it accounts forthe acquired asset. For a detailed example of the scopeexemptions, click here.

For example: On 30 June 20X9, a trader of Big Bank buys200 shares of ABC Company from Smaller Bank on VIRTEX(virtual exchange mechanism). The settlement date of thistrade is 3 July 20X9. The shares will be held for trading and,thus, measured at fair value through profit or loss. Big Bankapplies settlement date accounting. Consequently, Big Bankwill start to recognize the shares it its trading portfolio at 3July 20X9. However, it will recognize fair value changes onthose shares between 30 June 20X9 and 3 July 20X9 inprofit or loss

Loan commitments: credit arrangements to consumers fresidential mortgage loans or committed borrowing facgranted to corporate entities

Non-financial items: a commodity (such as wheat or sugor other goods and services (for example, inventory ortelecommunication services)

Question 1True or false: all financial guarantees issued are within the scopeIAS 39.

An issuer's rights and obligations arising under an insurance contract that isfinancial guarantee contract is usually within the scope of IAS 39, provided meets the definition of a financial guarantee contract in IAS 39.9. However,an issuer of financial guarantee contracts has previously asserted explicitlythat it regards such contracts as insurance contracts and has used accountingapplicable to insurance contracts, the issuer may elect to apply either IAS 39or IFRS 4Insurance Contracts to such financial guarantee contracts. Theissuer may make that election contract by contract, but the election for eachcontract is irrevocable. Financial guarantees that do not meet the specificdefinition in IAS 39 are likely to be derivatives which should be recorded at

value through profit or loss.

Question 2True or false: a regular way purchase or sale of a financial asset excluded from the scope of IAS 39.

A regular way purchase or sale of a financial asset is always within the scopof IAS 39. The terms of delivery of the asset (that is, within the time frameestablished generally by regulation or convention in the marketplaceconcerned) will govern whether a derivative needs to be recognised for the

period between the trade date and the settlement date.

Question 3

Within the scope of IAS 32 and IAS 39, which of the following true for insurance contracts?A. Insurance contracts within the scope of IFRS 4 are included.B. Insurance contracts that provide for reimbursement of an incu

loss specific to the insured party are included.C. Derivative contracts embedded in insurance contracts are incl

if the derivative is not itself a contract within the scope of IFD. None of the aboveE. A, B and C are correct

Question 4Which of the following loan commitments is within the scope of39?

A. Loan commitments that cannot be settled netB. Loan commitments that are issued at the market interest rateC. Loan commitments designated as financial liabilities at fair va

through profit or lossD. When the entity has past practice of selling assets resulting fr

loan commitments shortly after originationE. C and D are correct

The loan commitments described in options A and B are not within the scopof IAS 39. Loan commitments that can be settled net and loan commitmentsthat are issued at below-market interest rates are included in the scope of IA39.

Question 5Which of the following recognition and measurement rules for lrights and obligations are within the scope of IAS 39?


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D. Neither A nor B is correct

Lesson 4: Derivatives

Derivatives: Overview

Derivatives can be either stand-alone or embedded within anothercontract.

Derivatives can be held by an entity for trading purposes or for riskmanagement purposes (economic or accounting hedges).

When working with derivatives, it is important to remember that theiridentification is not always straightforward. Because derivatives can bepart of a complex combination, their underlying economics can also becomplex. Accounting for derivatives is a specialist area and youshould involve a specialist early and often when working withderivatives.

Definition of derivatives

A derivative is defined as a financial instrument or other contract withinthe scope of IAS 39 if it has all three of the following characteristics:

Its value changes in response to the change in a specifiedinterest rate, financial instrument price, commodity price,foreign exchange rate, index of prices or rates, credit ratingor credit index, or other variable, provided in the case of anon-financial variable that the variable is not specific to aparty to the contract (sometimes called the underlying).

It requires no initial net investment or an initial netinvestment that is smaller than would be required for othertypes of contracts that would be expected to have a similarresponse to changes in market factors.

It is settled at a future date.

Derivatives are recorded in the statement of financial position at fairvalue with any change in fair value reported in profit or loss. (Thereare some exceptions to this for a derivative designated in certaineffective hedge relationships.) Derivatives may be either financialassets or financial liabilities depending on the fair value of thecontract. At inception, most non-optional derivative contracts have azero value.

Initial net investment - An exchange of currencies is not a netinvestment, and, likewise, an option is not a net investment, as thepremium paid is less than the investment that would be required toobtain the underlying financial instrument to which the option is linked.

Examples of derivatives

Example: Company A enters into an interest rate swap with ComY. The terms are that Company A pays a fixed rate of 8% andreceives a variable rate of three-month LIBOR (London InterbanOffered Rate), reset on a quarterly basis. The fixed and variableamounts are determined based on a 1,000 notional amount.Company A and Company Y do not exchange the notional amoand Company A pays or receives a net cash amount each quarterbased on the difference between 8% and three-month LIBOR.

The contract in the above example meets the definition of a deriregardless of whether there is gross or net settlement because itsvalue changes in response to changes in the underlying variableinterest rate (three-month LIBOR). Additionally, there is no initiinvestment, settlements occur at future dates, and it makes nodifference whether A or Y actually make the interest payments tother on a gross or net basis.

The underlying

Usually, a derivative has a notional amount but does not require holder or writer to invest or receive the notional amount at incepThe notional amount is used to determine the settlement amount

However, a derivative could also require a fixed payment or payof an amount that is variable (but not proportionally with a chanthe underlying) as a result of some future event that is unrelated notional amount.

Example: A contract that requires a fixed payment of 1,000 if six-month Lincreases by 100 basis points is a derivative and has an underlyinvariable (six-month LIBOR), but it does not have a specified noamount.

Examples of underlying and notional amount:

Derivative Underlying Notional

Foreign currencyforward Exchange rate

Number of currencyunits

Interest rate swap Interest index Stated referenceamount

Currency swap Exchange rateSpecified currencyamount

Interest rate cap Interest index Stated referenceamount

Commodity future CommoditypriceNumber of commodityunits

Stock option Stock price Number of shares

Types of derivatives

Forward and future contracts A forward contact is a legal contract between two parties to purcand sell a specific quantity of a commodity, foreign currency, orfinancial instrument at a price specified with delivery and settlema specified future date. The purpose of a forward contract is to loa price and quantity for the future delivery of the item and is usemany of the same instances as futures contracts but as they can


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exchange. Unless centrally cleared, each party to the contract issubject to the default of the other party (credit risk).

Example: Entity A enters into a forward contract with Entity B on 1January 2006 to receive $10 million and pay 6.6 million on 1 January2007.

A futures contract is an exchange-traded legal contract to buy or sell astandard quantity and quality of a commodity, financial instrument, orindex at a specified future date and price. Entities typically use futurescontracts as hedging instruments to protect themselves against pricerisk or interest rate risk. Futures contracts are traded on a regulatedexchange and result in less credit risk than forward contracts.

Example: on 30 September 2005, Entity A enters into a futures contractto buy 100 tons of wheat at a future price of 73 per ton in July 2006.

Options An option is a contract giving its owner the right, but not the obligation,to buy (call) or sell (put) a specified commodity, foreign currency, orfinancial instrument at a fixed price (exercise or strike price) during aspecified period of time (American option) or on a specified date(European option). The buyer pays a non-refundable fee (thepremium) to the seller (the writer) for this benefit. Entities use optionsas hedging instruments to protect themselves against adversechanges in share and commodity prices, interest rates and foreigncurrency exchange rates, as well as for speculative purposes.

Example: An entity purchases a put option from an issuer for oil on 1January 2006. The option is for three months with a strike price of$22.50 on 100,000 barrels of oil. The holder is not required to exercisethe option and can let the option expire if it does not require the supply ofoil or if the price of oil falls below the strike price (as it is cheaper topurchase the oil in the marketplace rather than exercise the option).

Cap/Floor and collar

An interest-rate cap (floor) is an over-the-counter (OTC) instrumentthat protects the holder from increases (decreases) in short-terminterest rates by making a payment based on a notional principalamount to the holder when an underlying interest rate (the index orreference interest rate) exceeds (or falls below) a specified strikerate (the cap rate or floor rate).Caps (or floors) are purchased for apremium and typically have expirations between one and seven years.Payments are made to the holder on a monthly, quarterly, or semi-annual basis, with the period generally set equal to the maturity of theindex interest rate. The payments are essentially a series of interestrate options bundled together in one instrument.

Example: CAP Assume a three-year, 200,000 notional principal

amount interest rate cap with six-month LIBOR as its index rate, with astrike price of 7.5%. If the six-month LIBOR interest rate increases above7.5%, the holder will receive payments for the difference based on the200,000 notional.

A collar is a combination of a cap and a floor. The premium due for thecap is partially offset by the premium received for the floor (or viceversa), making the collar an effective way to hedge interest rate risk atlow cost. In return for this protection, the entity gives up the potentialbenefit of favorable rate movements outside the band defined by thecollar.

Example: COLLAR A customer is borrowing from ACD Bank $200,000at a six-month LIBOR +2% interest rate of 7.75% (six-month LIBOR iscurrently 5.75%). The customer wishes to cap LIBOR so that it does notexceed 6% (the strike price). The customer buys a cap and pays thebank $1,500. If the six-month LIBOR interest rate increases above 6%,

In order to reduce the cost of the cap, the borrowersells a floor t ACD bank with a strike rate of 4%. The bank and the customhave created a band (the collar) within which the custompay LIBOR + 2%. If the LIBOR drops below the floor, thecustomer compensates ACD bank. If LIBOR rises above th ACD bank compensates the customer.

Interest Rate Swap An interest rate swap is a contract between two parties to exchan

interest payments on a specified notional principal amount (referas the notional amount) for a specified period in the future. Genean interest rate swap involves the exchange of streams of variabfixed-rate interest payments. Interest rate swaps allow an entity taccess funding in the financial markets that is readily available tbut are able to convert (swap) it into the funding rate required.

Company Y issues 100,000 debt which pays three-month LIBOR oa quarterly basis. Company Y would like to fix its interest raexposure relating to the debt issuance. Company Y enters into aninterest rate swap with Company Z. The terms are that Companypays a fixed rate of 8% and receives a variable amount based onthree-month LIBOR on a quarterly basis; the fixed and variable

amounts are determined based on a 100,000 notional amount. Y Z do not exchange the notional amount and Company Y pays orreceives a net cash amount each quarter based on the differencebetween 8% and three-month LIBOR.

Currency Swap A currency swap is an exchange of principal denominated in twodifferent currencies at the current (spot) rate, under an agreemenrepay the principal at a specified future date at a specified rate.

Company ABC enters into a five-year fixed-for-fixed currency seuro and US dollar. Company ABC will receive euro currency aof 5.68% on 100 million and pay in dollar currency at a rate of

on $130 million. There will be a final exchange of principal on mof the swap contract based on the current $1.3:1 spot exchangebetween the dollar and the euro.

Embedded derivatives

An embedded derivative is a component of a combined (hybrid)instrument that also includes a non-derivative host contract. Anembedded derivative has implicit or explicit terms that affect theflows or value of other exchanges required by the combinedinstrument in a manner similar to a stand-alone derivative.

An embedded derivative causes some or all of the cash flows thaotherwise would be required by the contract, to be modified accoto a specified variable (an underlying such as an interest rate, acommodity price, a foreign exchange rate, a credit rating or credindex) provided, in the case of a non-financial variable, that thevariable is not specific to a party to the contract.

A derivative that is attached to a financial instrument but iscontractually transferable independently of that instrument or hadifferent counterparty from that instrument is not an embeddedderivative, but a separate financial instrument.

Host contracts and hybrid instruments Ahost contract is a non-derivative debt instrument, equity instrulease contract or other non-financial contract.

A hybrid instrument is a combination of a non-derivative host


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Examples include: A three-year certificate of deposit which entitles the investor

to receive a fixed 3% interest plus any additional positivereturn, if any, of the S&P index; this is a hybrid financialinstrument because it is composed of a host instrumenttogether with an equity option on the S&P index.

A three-year certificate of deposit which entitles the investorto receive a fixed 3% interest plus any additional positivechanges in the six-month LIBOR rate

Separation of embedded derivatives

An embedded derivative must be separated for recognition andmeasurement purposes from the host contract when it meets the threecriteria listed below. When an embedded derivative is required to beseparated from the host contract it needs to be accounted forseparately at fair value through profit or loss.

An embedded derivative must be separated from the host contractwhen the following three conditions have been met:

The combined instrument is not measured at fair value withchanges in fair value recognized in profit of loss.

A separate instrument with the same terms as theembedded derivative would meet the definition of aderivative.

The economic characteristics and risks of the embeddedderivatives are not closely related to the economiccharacteristics and risks of the host contract.

Embedded derivatives closely related to the hostcontract

When determining whether the embedded derivative is closely rthe following must be considered: (1) type of host and (2) theunderlying of the embedded derivative.

Some examples where the embedded derivative would be considclosely related to the host contract include the following:

Debt host contracts and embedded derivative withunderlying indexed to interest, inflation, or creditworth

Equity host contracts and underlying indexed to price o

share in an entity Lease host contracts and underlying indexed to inflatiointerest

Examples of embedded derivatives that are not closely related tohost contract:

A put option embedded in a debt instrument that enableholder to require the issuer to reacquire the debt instrumfor an amount of cash that varies based on the change iequity or commodity price or index is not closely relatehost debt instrument.

Equity-indexed interest or principal payments embeddehost debt instrument by which the amount of interest orprincipal is indexed to the value of equity instruments aclosely related to the host debt instrument because the rinherent in the host (interest rate) and the embeddedderivative (equity) are dissimilar.

Commodity-indexed interest or principal paymentsembedded in a host debt instrument by which the amouinterest or principal is indexed to the price of a commo(such as gold) are not closely related to the host debtinstrument because the risks inherent in the host (intererate) and the embedded derivative (commodity) aredissimilar.

Multiple embedded derivatives

In certain cases, a host contract contains more than one derivativThe purpose of containing multiple derivatives in a host contracalleviate more than one risk (for example, foreign exchange riskcredit risk). Generally, embedded multiple derivatives in a singleinstrument are treated as a single compound instrument when threlate to the same risk exposures. However, when an instrument multiple embedded derivatives and those derivatives relate to dirisk exposures and are readily separable and independent of oneanother, they are accounted for separately unless they are clearlyclosely related to the host contract. Embedded derivatives classias equity are accounted for separately from those classified as asor liabilities.

The following are two examples of host contracts that contain membedded derivatives:

Assume a debt instrument includes a forward and an opcomponent linked to an equity index. It is not appropriaseparate both a forward and an option on the equity indbecause those derivative features relate to the same riskexposures. Instead, the forward and option elements artreated as a single compound embedded derivative. Forsame reason, an embedded floor or cap on interest ratesshould not be separated into a series of floorlets andcaplets (i.e., a series of individual of interest optionindividual periods).

A hybrid debt instrument contains two options giving tholder a right to choose both the interest rate index on wh i d i d d h


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relate to different risk exposures (interest rate risk andforeign exchange risk) and are readily separable andindependent of one another.

Question 1Which of the following is a criterion for a derivative?A. Its value changes in response to changes in an underlying variable.B. It requires no, or a comparatively smaller, initial net investment.

C. It is settled at a future date.D. None of the aboveE. All of the above

Question 2 A contract giving its owner the right, but not the obligation, to buy orsell a specified commodity, foreign currency, or financial instrument ata fixed price during a specified period of time or on a specified date.Which financial instrument does this describe?A. Interest rate swapB. Commercial paperC. OptionD. Credit-linked note

Question 3Which of the following statements is true?

A. An interest rate swap requires payment of the notionalprincipal amount at maturity of the contact.B. An interest rate swap embedded in a debt host instrument isconsidered closely related.

A. AB. BC. Both A and BD. Neither A nor B

An interest rate swap requires periodic interest payments based on the

notional amount but does not require payment of the notional amount atmaturity.

Question 4Which of the following statements is (are) true about the requirementsfor separation of embedded derivatives from the host contract?A. The economic characteristics and risks of the embedded derivative

are not closely related to those of the host contract.B. A separate instrument with the same terms as the embedded

derivative meets the definition of a derivative.C. The hybrid instrument is not measured at fair value through profit or

loss.D. All of the above are true.

Question 5True or false: an embedded derivative is a component of a hybridinstrument.

An embedded derivative is a component of a hybrid instrument that alsoincludes a non-derivative host contract.

Question 6True or false: an entity purchases a bond in which the coupon rate iszero and the principal varies based on the London gold index. Thisproduct is commonly referred to as a leveraged gold note. Theembedded derivative is closely related to the host contract.

Lesson 5: Debt vs. Equity

Equity instruments

This area of financial instrument accounting, covered by IAS 32concern to entities as, depending on the classification of a financinstrument issued by the entity (that is, debt, i.e., a financial liabequity), the financial instrument could potentially have a negativimpact on the entity. For example, when an instrument is classifdebt by the issuer, gearing (leverage) and solvency ratios are affdebt covenants could be breached, capital adequacy tests imposeregulatory agencies could be breached, and the payments wouldclassified as interest rather than dividends.

An equity instrument is any contract that evidences a residual inin the assets of an entity after deducting all of its liabilities. Onedistinguish a financial liability from equity is to ascertain whethis a contractual obligation to deliver cash or another financial asFor example, the holder of an equity instrument is entitled to recdividends or distributions but there is no contractual obligation fentity to return principal (that is, the amount invested).

IAS 32 requires that for an instrument to be classified as an equiinstrument by the issuer, both of the following conditions shouldmet:

(a) The instrument includes no contractual obligation:(i) To deliver cash or another financial asset to another en

or(ii) To exchange financial asset or financial liabilities with

another entity under conditions that are potentiallyunfavorable to the issuer.

(b) Ifthe instrument will or may be settled in the issuers own instruments, it is:(i) A non-derivative that includes no contractual obligatio

the issuer to deliver a variable number of its own equiinstruments; or

(ii) A derivative that will be settled only by the issuerexchanging a fixed amount of cash or another financiaasset for a fixed number of its own equity instrumentssubject to certain exclusions within IAS 32.

Own equity instruments examples

When applying the second condition for classification as an equinstrument, it should be noted that a contract is not classified as by the issuer solely because it may result in the delivery of an enown equity instruments. If the instrument will or may be settled issuers own equity instruments, as per the definition of an equitinstrument it is:

anon-derivative that includes no contractual obligation forissuer to deliver a variable number of its own equity instrum

The following is an example of when the condition above is not XYZ has entered into a contract with CDD to deliver its own shworth 150,000. XYZ shares are listed on Hypothetical Exchanexample, if an XYZ share is worth 5 on settlement date, XYZ wrequired to deliver 30 000 shares to CDD; if however the marke


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The number of own shares that XYZ will have to issue varies with theprice of XYZ shares given on Hypothetical Exchange. Although XYZmust settle the contract by delivering its own equity instruments, afinancial liability exists because XYZ uses a variable number of its ownequity instruments to settle the contract with CDD. As the obligation ofXYZ is always fixed at 150,000 and the number of shares to bedelivered will vary, the contract entered into by XYZ and CDD doesnot represent a residual interest in XYZs assets after deducting all of

its liabilities as CDD does not take on equity risk as CDD will alwaysreceive 150,000 worth of XYZ shares regardless of the market price(that is, it does not take on the market price volatility movement ofXYZs share price). Therefore, the condition in (b)(i) on the previouspage is not met and the contract would be classified as a financialliability.

If the instrument will or may be settled in the issuers own equityinstruments, as per the definition of an equity instrument it is:

a derivative that will be settled only by the issuer exchanging afixed amount of cash or another financial asset for a fixed numberof its own equity instruments, subject to certain exclusions within

IAS 32. An example of when the condition above is met:XYZ issues a share option on 1 January 2009 to CDD to purchase150,000 XYZ shares at an exercise price of 5 in two months. CDDhad paid XYZ a premium of 80,000 to purchase the option.

At 1 February 2009, the share price of XYZ is 4.65; if the share priceof XYZ is greater than 5 in one month, CDD will exercise its option topurchase 150,000 shares in XYZ for 750,000. If, on the other hand,the share price of XYZ does not exceed 5 in one month, CDD will notexercise its option to purchase XYZ shares as it is cheaper topurchase the shares in the open market. In this scenario, CDD is

exposed to changes in the share price (equity risk) as CDD is notguaranteed to receive 750,000 in value, and the quantity of shares itreceives for this amount will depend upon the market price of theshares when the option vests (that is,in two months time). As thecontract is a derivative that will be settled only by XYZ (the issuer)exchanging a fixed amount of cash for a fixed number of its own equityinstruments, the nature of the contract is equity.

Compound financial instruments

It is possible that a non-derivative financial instrument hascharacteristics of an asset, liability, equity or all three instruments.Under these circumstances IAS 32 requires that the instrument besplit into its various components (that is, financial asset, financialliability and equity as applicable), each of which should be classifiedseparately in the financial statements of the entity.

The following is an example of a compound financial instrument:

CDD issues a convertible bond which is convertible by the holder intoa fixed number of equity instruments of CDDs ordinary shares. FromCDDs perspective, the convertible bond includes two components: afinancial liability and equity. The financial liability is the contractualobligation to deliver cash or another financial asset and the equityinstrument is the call option granting the holder the right, for aspecified period of time, to convert the instrument into a fixed numberof ordinary shares of CDD.

In the case of a compound financial instrument, the issuer splits the

Question 1Which of the following financial instruments meets the criteria fclassification as equity by the issuer?

A. A written call option granting the holder the right to purchaseamount of the entitys own shares at a fixed price at a fixed dthe future

B. A written call option granting the holder the right to purchaseamount of the entitys own shares atthe future market priceprevailing at the date of exercising the option, at a fixed datefuture

C. A written call option granting the holder the right to purchaseamount of the entitys own shares at a fixed price at a date todetermined by the holder

D. Answers 1 and 3 are correct.

Question 2True or false: financial instruments that contain both a liability aequity component (compound instruments) must be split andaccounted for separately.

Question 3Which of the following statements is true regarding the IAS 32definition of an equity instrument?

A. An equity instrument is a contract that evidences a residuinterest in the assets of an entity after deducting all of itsliabilities.

B. An equity instrument is a contract that evidences voting in the entity.

A. Only statement A is true.B. Only statement B is true.C. Both statements A and B are true.D. Neither statement A nor B is true.

Question 4 A convertible bond is a debt instrument that can be converted infixed number of ordinary shares of the issuer at the option of theholder. Should this instrument be classified as:

A. A financial liabilityB. An equity instrumentC. A compound instrument that must be split into its liabilit

equity componentsA. The correct answer is A.B. The correct answer is B.C. The correct answer is C.D. None of answers A, B or C is correct.

ASSESSMENT

Question 1Read the list of terms on the left. Then enter the number that clomatches each definition on the right.


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[ 4 ] Equity instrument

[ 2 ] Financial asset

[ 5 ] Fair value

[ 3 ] Financial liability

[ 1 ] Financial instrument

1. A contract that gives rise to both a financial asset in one entity and afinancial liability or equity instrument in another entity

2. Cash, equity instrument of another entity, or contractual right toreceive cash or another financial asset from another entity

3. Contractual obligation to deliver cash or another financial asset toanother entity, or to exchange financial instruments with another

entity underpossibly unfavorable conditions to the entity 4. Any contract that evidences a residual interest in the assets of an

entity after deducting all of its liabilities5. The price that would be received to sell an asset or paid to transfer a

liability in an orderly transaction between market participants at themeasurement date

Question 2True or false: the rules for measurement of financialinstruments are located within IAS 39.

Question 3

When would a financial guarantee issued by an entitynot beconsidered to be within the scope of IAS 32/39?A. If it does not meet the particular definition in IAS 39 or when

the entity issuing the guarantee has previously assertedthat it regards such contracts as insurance contracts, hasused accounting applicable to insurance contracts and haselected to apply IFRS 4

B. If it is defined as a business riskC. If it is considered to be a foreign currency liability

Question 4Which of the following is a criterion for a derivative?A. Its value changes in response to changes in an underlyingvariable.B. It requires no, or a comparatively small, initial netinvestment.C. It is settled at a future date.D. None of the aboveE. All of the above

Question 5What Standard(s) would apply to a loan commitment that is notwithin the scope of IAS 39?A. IAS 18B. IAS 37C. IAS 32D. A and B are correctE. A and C are correct

Question 6 A derivative financial instrument is recognized as a/an:A. financial assetB. equity instrumentC. financial liabilityD. A and B are correct

E. A, B and C are correct

Question 7True or false: IAS 32Financial Instruments: Presentation andIAS 39Financial Instruments: Recognition and Measurement apply to all financial instruments.

Question 8When are derivatives classified in equity?A. If the contract was settled by exchanging a fair value

amount of an entitys own equity instruments for a fixedamount of cash or other financial assets

B. If and only if the contract will be settled by exchanging afixed amount of an entitys own equity instruments for afixed amount of cash or other financial assets, subject tocertain exclusions within IAS 32

C. If and only if the contract was settled by adding a fixedamount of an entitys own equity instruments to a fixedamount of cash or other financial assets

D. If the contract will be settled by subtracting a fair valueamount of an entitys own equity instruments from a fairvalue amount of cash or other financial assets

Documents

Financial Instruments 1 (training)