Financial Instruments

LESSON 8

Reference Chapter :

Chapter 14

Financial Accounting & Reporting

Barry Elliott & Jamie Elliott

In general :

Financial instruments is a highly complex area. Financial instruments are in nature complex due to recognition, measurement as well as derecognition of financial instruments in the financial statements.

In accounting for financial instruments, it has involved political involvement in setting accounting standards for financial instruments.

As such, the accounting standards in financial instruments are still developing and undergoing debates.

Objectives

By the end of this chapter, you should be able to:• define what financial instruments are and be able to

outline the main accounting requirements under IFRS;

• comment critically on the international accounting requirements for financial instruments and understand why they continue to prove both difficult and controversial topics in accounting;

• account for different types of common financial instrument that companies may use.

Financial assets – IAS 32

• Cash• Contractual right to receive cash• Contractual right to exchange financial

instruments on favourable terms• An equity instrument

Financial liabilities – IAS 32

• Contractual obligation to deliver cash • Contractual obligation to exchange financial

instruments on unfavourable terms.

Liability or equity – IAS 32

• Preference shares may be treated as a liability– Mandatory redemption

• Fixed rate• Fixed date

– Accelerated dividends• Redemption commercially expedient

– Holder has option to redeem • Highly likely future event

Compound instruments – IAS 32

Convertible loans• Proceeds

– Divide proceeds into two parts

– Debt and equity option.

• Value

– Value debt with equity as residual

– Value each part.

Compound instruments illustration

Convertible debentures1 January 2000 1,000 £100 5% issued at par

1 January 2005 Convert into 50 ordinary shares

per £100 OR redeem at par

Interest rate on similar debentures is 6%.

Compound instruments illustration (Continued)

The four categories of financial instruments IAS 39

• Financial assets or liabilities at fair value through profit or loss

• Held-to-maturity investments• Loans and receivables• Available-for-sale financial assets

Each is defined in the following slides.

Financial assets or liabilities at fair value through profit or loss

• Assets and liabilities under this category are reported in the financial statements at fair value.

• Changes in the fair value from period to period are reported as a component of net income.

• There are two types of investments that are accounted for under this heading:– held-for -trading investments

– designated on initial recognition.

Held-for-trading investments

• These are financial instruments where– the investor’s principal intention is to sell or

repurchase a security in the near future and where there is normally active trading for profit-taking in the securities; or

– they are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent pattern ofshort-term profit-taking; or

– they are derivatives. This category includes commercial papers, certain government bonds and treasury bills.

Designated on initial recognition

A company has the choice of designating as fair value through profit or loss on the initial recognition of an investment in the following situations:• it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and

losses on them on different bases; or• a group of financial assets, financial liabilities or both is managed and performance is evaluated on a fair value basis, in

accordance with a documented risk management or investment strategy; or

• the financial asset or liability contains an embedded derivative that would otherwise require separation from the host.

Reclassification following the credit crunch

• Prior to October 2008, it was prohibited to transfer instruments either into or out of the fair value through profit or loss category after initial recognition of the instrument.

• Following significant pressure that the international standards were more restrictive than US GAAP in this area, the IASB amended the standard to allow reclassification of financial instruments in rare circumstances.

• The financial crisis of 2008 was deemed to be a rare situation that would justify reclassification.

• The reclassification requirements allow instruments to be transferred from the fair value through profit and loss to the loans and receivables category.

Held-to-maturity investments

• These include corporate and government bonds and redeemable preference shares which can be held to maturity.

• They are instruments with fixed or determinable payments and fixed maturity for which the entity positively intends and has the ability to hold to maturity.

• For items to be classified as held-to-maturity an entity must justify that it will hold them to maturity.

• The investments are initially measured at fair value (including transaction costs) and subsequently measured at amortised cost using the effective interest method, with the periodic amortisation recorded in the income statement.

• As they are reported at amortised cost, temporary fluctuationsin fair value are not reflected in the entity’s financial statements.

Loans and receivables

• This includes trade receivables, accrued revenues for services and goods, loan receivables, bank deposits and cash at hand.

• They have fixed or determinable payments that are not quoted in an active market.

• They are initially measured at fair value (including transaction costs) and subsequently measured at amortised cost using the effective interest method, with the periodic amortisation in the income statement.

Available-for-sale financial assets

• A common example is an equity investment in another entity.

• On initial recognition the asset is reported at cost and at period-ends it is restated to fair value with changes in fair value reported under other comprehensive income.

• If the fair value falls below the amortised cost and the fall is not estimated to be temporary, it is reported in the investor’s statement of comprehensive income.

Available-for-sale financial assets (Continued)

• The fair value of publicly traded securities is normally based on quoted market prices at the year-end date.

• If not publicly traded, assessed using a variety of methods and assumptions based on market conditions existing at each year-end date referring to quoted market prices for similar or identical securities if available or employing other techniques such as option pricing models and estimated discounted values of future cash flows.

Example of accounting for an available-for-sale financial asset

• Brighton plc acquired shares in Hove plc.• On 1 September 20X9 June Brighton purchased

15 million of the 100 million shares in Hove for £1.50 per share.

• The Brighton directors are not able to exercise any influence over the operating and financial policies of Hove.

• The shares are currently in the Statement of Financial Position as at 31 December 20X9 at cost and the fair value of a share was £1.70.

Brighton example

• Brighton owns 15% of the Hove issued shares.• As the directors are not able to exercise any

influence, it is not an associate.• The investment is dealt with under IAS 39

Financial Instruments: Recognition and Measurement as an available-for-sale financial asset.

• It has to be valued at fair value, with gains or losses taken to equity.

Brighton example treatment

• The investment is valued at £25.5 million (15 million × £1.70).

• There is a gain of £3 million (15 million × [£1.70 − £1.50]).

• The gain is taken to equity through other comprehensive income.

Recognition of financial instruments

• Initial recognition of a financial asset or liability is when it becomes party to the contractual provisions of the instrument.

• Derivative instruments must be recognised on the statement of financial position if a contractual right or obligation exists.

Derecognition of financial instruments

• Financial assets should only be derecognised from the statement of financial position when the enterprise transfers the risks and rewards that comprise the asset.

• If it is not clear whether the risks and rewards have been transferred, the entity considers whether control has passed.

• If control has passed, the entity should derecognise the asset.

• On derecognition, any gain or loss should be recorded in the statement of income.

Derecognition of financial instruments (Continued)

• Financial liabilities should only be derecognised when the obligation is– discharged

– cancelled or

– expired.

Measurement of financial instruments

Initial measurement

Financial assets and liabilities should be initially measured at fair value plus transaction costs. In almost all cases, this would be at cost.

Subsequent measurement

Figure 14.3 summarises the way that financial assets and liabilities are to be subsequently measured after initial recognition.

Subsequent measurement of financial instruments

Figure 14.3 Subsequent measurement

Subsequent measurement of financial instruments (Continued)

Figure 14.3 Subsequent measurement (Continued)

Hedging

• There are three types of hedging instrument:– fair value hedge

– cash flow hedge

– net investment hedge.

Hedging – fair value hedge

• A hedge of the exposure to changes in fairvalue of – a recognised asset or

– liability or

– an unrecognised firm commitment.

• Any gain or loss arising on remeasuring the hedging instrument and the hedged item should be recognised in the income statement in the period.

The standard requires disclosure of

1.The significance of financial instruments for the entity’s financial position and performance (many of these disclosures were previously in IAS 32).

2.Qualitative and quantitative information about exposure to risks arising from financial instruments, including specified minimum disclosures about credit risk, liquidity risk and market risk.

IFRS 7 – main requirements

The qualitative disclosures describe management’s objectives, policies and processes for managing those risks.

IFRS 9 – recognition and measurement

IFRS 9 has only two measurement bases for financial assets – fair value or amortised cost

• End of Lesson

• Please complete all theory and practice questions