FINANCIAL INSTRUMENT

A financial asset of one entity

Financial Asseta) Cash;b) an equity instrument of another entity;c) a contractual right:

1. to receive cash or another financial asset from another entity; or

2. To exchange financial assets or financial liabilities under conditions that are potentially favorable to the entity

d) a contract that will or may be settled in the entity’s own equity instruments and is:

1. a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or

2. 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.

Either a financial liability or an equity instrument of another entity.

Financial Liability

a) a contractual obligation:1. to deliver cash or another financial asset to

another entity; or2. To exchange financial assets or financial

liabilities under conditions that are potentially unfavorable to the entity

b) a contract that will or may be settled in the entity’s own equity instruments and is:

1. 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

2. 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.

is any contract that gives rise to both:

An equity instrument is a contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities and represents a financial asset of the holder and equity of the issuer.

CLASSIFY?Debtors Bank Loan Investment in TFCs TFCs issuedInventory Prepayments Advances from customers Shares issuedProvision for taxes Dividends payable WPPF payable Creditors

• Some financial instruments, called compound instruments, have both a liability and an equity element.• In case this case, IAS 32 requires the component parts to be separated from each other, with each part accounted for and

presented separately according to its substance.• To illustrate, a convertible bond contains two components.

• – One is a financial liability, the issuer’s contractual obligation to pay cash (principal and interest on the bond), and• – The other is an equity instrument, a call option written to the holder to convert the debt security into common shares.

• The separation of components is made at the time the instrument is issued and is not subsequently revised as a result of a change in interest rates, share price, or other event that changes the likelihood that the conversion option will be exercised.

Compound Instruments

Illustration

DT plc issues– 2,000 convertible bonds at the start of 2008– The bonds have a three‐year term,– Issued at par with a face value of €1,000 per bond.– Interest is payable annually in arrears at 6%.– Each bond is convertible at the holders’ discretion at any time up to maturity into 250 ordinary common shares of DT plc.

The present value of bond cash flows at a market rate (say 10%) of interest for a similar financial instrument without the equity conversion option ‐ €1,801,052 . This is the liability component.

The difference between the issue proceeds, €2,000,000, and the fair value of the liability component is assigned to the equity component €198,948.

Dr. Bank 2,000,000Cr. Financial Liability 1,801,052Cr. Equity 198,948

• Issue cost relating to issuance of equity shall be deducted from equity

• Transaction cost relating to issuance of liability shall be deducted from liability

• Transaction cost on compound financial instrument will be allocated on prorata basis of initially recognized amounts.

• Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognized as income or expense in profit or loss

• Distribution to holders of an equity instrument shall be debited by the entity directly to equity, net of any related tax benefit.

Issue Cost Income Statement Classification

TYPES/ CLASSIFICATION OF FINANCIAL INSTRUMENTS

Option available to designate at FVTPL if such designation reduces

inconsistency or instrument is evaluated on FV basis

Option available to designate at FVTPL even

if intstrument meets these two tests.

Financial Instruments

Financial Asset

Equity instrument

At FV through OCI

At FV through PL

Debt instrument

At FV through PL

Amortised cost

Business model test

Cash flow characteristics test

Financial Liability

At FV through PL

Amortised cost

ACCOUNTING OF FINANCIAL INSTRUMENTS INITIAL REPORTING DATE

Financial Instrument

Financial Asset

Equity instrument

At FV through OCI FV + transaction costFV gain/loss in OCI (don't

classify to P/L on disposal)

At FV through PL FV (transaction costs are expensed out)

FV gain/loss in income statement

Debt instrument

At FV through PL FV (transaction cost are expensed out)

FV gain/loss in income statement

Amortised cost FV + transaction costDiscounted cash flows -

interest income in P/L on effective interest

Financial Liability

At FV through PL FV FV gain/loss in income statement

Amortised costDiscounted cash flows (transactions costs are

deducted from proceeds)

Discounted cash flows -interest expense in P/L on

effective interest

FVTPL and FV through OCIComparison Illustration

Jones buys an investment for $40 million. The transaction costs are $1 million.. At the year end the value of the asset has risen to $60 million.Shortly after the year end the asset is sold for $70 million.

How should this be accounted for if the investment is classified as:– Fair value through profit and loss– FV through OCI

Effective interest rate method

The effective interest rate is the internal rate of return (IRR) or the level yield to maturity, i.e. the rate that exactly discounts the estimated future cash flows or receipts through the expected life of the instrument, or where appropriate, a shorter period, to the net carrying amount at initial recognition.

On January 20X1 James issued a deep discount bond with a Rs 50,000 nominal value. The discount was 16% of nominal value and the costs of issue were Rs 2,000.Interest of 5% is payable annually in arrears. The bond must be redeemed on 1 January 20X6 at a premium of Rs 4,611.The effective rate of interest is 12% p.a.Required:How will this be reported in financial statements of James over the period to redemption.

Financial Liability at Amortized Cost ‐ Illustration

On 1 January 20X8, Charlton purchased $6m 3.5% redeemable debt. The transaction costs amounted to $120,000. The debt is redeemable on 31 December 20Y3 at a premium of 30%. Effective interest rate is 7.25%

Financial Asset ‐ Debt Instrument

What investment income should be recorded each year in respect of the debt instrument?

Recognition of Financial Asset and Financial LiabilityAn entity shall recognise a financial asset or a financial liability in its statement of financial position when, and only when, the entity becomes party to the contractual provisions of the instrument.

When an entity first recognises a financial asset/financial liability, it shall classify it as discussed earlier and measure it accordingly.

Regular Way Contracts

• Contracts to buy or sell financial assets (for example, contracts to buy securities on an exchange) will have standard delivery terms prescribed by the exchange. For example, transactions of securities may be required by the exchange days to be settled three after the trade date – a trade taking place today must be paid for (if purchased) or delivered (if sold) three businesses days from the trade date. For example a trade executed on 11 May settles on 14 May. This kind of settlement is known as regular way settlement.

• The fixed price commitment between trade date and settlement date is a forward contract that meets the definition of a derivative. However, because of the short duration of the commitment, such a contract is not recognized as a derivative financial instrument under IFRS 9.

• The standard permits either trade date accounting or settlement date accounting for regular‐way purchases or sales of a financial asset

• Trade date accounting’ and ‘settlement date accounting’ refer to methods of recognizing an asset acquired (and any associated liability incurred) and derecognizing an asset sold (and any associated receivable recognized).

• The method used must be applied consistently for all purchases and sales of financial assets that belong to the same category of financial assets, as defined in IFRS 9.

The choice of method is an accounting policy.

Purchase of Financial AssetOn 29 December 20X1, an entity commits itself to purchase a financial asset for CU1,000, which is its fair value on commitment (trade) date. Transaction costs are immaterial. On 31 December 20X1 (financial year-end) and on 4 January 20X2 (settlement date) the fair value of the asset is CU1,002 and CU1,003, respectively.

Sale of Financial AssetOn 29 December 20X2 (trade date) an entity enters into a contract to sell a financial asset for its current fair value of CU1,010. The asset was acquired one year earlier for CU1,000 and its amortized cost is CU1,000. On 31 December 20X2 (financial year-end), the fair value of the asset is CU1,012. On 4 January 20X3 (settlement date), the fair value is CU1,013.

IMPAIRMENT OF FINANCIAL ASSET

Impairment of Financial Asset

At Fair value

Not required separately… FV Gain/Loss to be calculated only

At Amortized cost

Carrying Value Less: PV of revised cash flows using original effective interest rate

Included in the financial assets of Traveler is a ten-year 7% loan. At 30 November 2011, the borrower was in financial difficulties and its credit rating had been downgraded. Traveler has adopted IFRS 9 Financial Instruments and the loan asset is currently held at amortized cost of $29 million. Traveler now wishes to value the loan at fair value using current market interest rates. Traveler has agreed for the loan to be restructured; there will only be three more annual payments of $8 million starting in one year’s time. Current market interest rates are 8%, the original effective interest rate is 6·7% and the effective interest rate under the revised payment schedule is 6·3%.

What amount would be reported in SFP as at 30-Nov-2011 and what amount would be charged as impairment (if any).

Example

The basic premise for the derecognition model in IFRS 9 is to determine whether the asset under consideration for derecognition is:• an asset in its entirety or• specifically identified cash flows from an asset (or a group of similar financial assets) or• a fully proportionate (pro rata) share of the cash flows from an asset (or a group of similar financial assets). or• a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or a group of

similar financial assets)

Once the asset under consideration for derecognition has been determined, an assessment is made as to whether the asset has been transferred, and if so, whether the transfer of that asset is subsequently eligible for derecognition.

An asset is transferred if either the entity has transferred the contractual rights to receive the cash flows, or the entity has retained the contractual rights to receive the cash flows from the asset, but has assumed a contractual obligation to pass those cash flows on under an arrangement that meets the following three conditions:• the entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts on the

original asset• the entity is prohibited from selling or pledging the original asset (other than as security to the eventual

recipient),• the entity has an obligation to remit those cash flows without material delay

Once an entity has determined that the asset has been transferred, it then determines whether or not it has transferred substantially all of the risks and rewards of ownership of the asset. If substantially all the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been retained, derecognition of the asset is precluded.

If the entity has neither retained nor transferred substantially all of the risks and rewards of the asset, then the entity must assess whether it has relinquished control of the asset or not. If the entity does not control the asset then derecognition is appropriate; however if the entity has retained control of the asset, then the entity continues to recognise the asset to the extent to which it has a continuing involvement in the asset.

De‐recognition of Financial Asset

ExampleBell buys an investment for trading purposes from Book. It cost $10 million at 1 January 20X7. At 31 December 20X7, the investment had a fair value of $30 million. On 1 June 20X8 Bell sold the investment to Candle for its market value of $100 million.1. How should this be accounted for?2. Would the answer have been different if Bell’s purchase contract had contained a put option giving Bell the power to sell the investment back to Book at market value on 31 December 20X8?3. Would the answer have been different if Bell’s sale contract had provided Bell with a call option and Candle with a put option over the investment, each at a price of $105 million over the next 12 months?

Summer 2012

Zee Power Limited (ZPL) has been facing short term liquidity issues during the financial year ended on 31 December 2011. As a result, the following transactions were undertaken:

i On 27 December 2011, ZPL sold its investment in listed Term Finance Certificates (TFCs) to Vee Investment Company Limited with an agreement to buy them back in 10 days. Relevant details are as follows:

Sale price 10,150,000 Buy back price 10,183,337 Value in ZPL’s books as on 27 December 2011 10,144,332 Market price as on 31 December 2011 10,163,125

ZPL intends to hold these TFCs till maturity.

ii On 1 January 2009, ZPL had obtained a bank loan of Rs. 100 million at 10% per annum. The interest was payable annually on 31 December and principal amount was repayable in five equal annual installments commencing from 31 December 2009. On 1 January 2011, the bank agreed to facilitate ZPL as follows:

On 27 December 2011, ZPL sold its investment in listed Term Finance Certificates (TFCs) to Vee Investment Company Limited with an agreement to buy them back in 10 days. Relevant details are as follows:

- Balance amount of the principal would be paid at the end of the loan’s term i.e. on 31 December 2013.

- With effect from 1 January 2011, interest would be paid at the rate of 10.5% per annum.

The market rate for similar debt is 10%.Required:Prepare journal entries to record the above transactions in the books of Zee Power Limited.

De recognition of Financial Liabilities

Generally a financial liability is derecognized only when it is relinquished, i.e. when the obligation is:

DischargedAn obligation is discharged if an entity delivers:– Cash– Other financial assets– Equity instruments of entity (IFRIC - 19)– Other goodsWhich the counterparty accepts as suitable compensation.

CancelledCancellation of an obligation only occurs through a process of law whereby anentity is legally released from its primary obligation to pay the creditor.

ExpiredAn obligation expires due to the passage of time.

Derecognition of Financial Liability

Extinguishment

Substantial change in terms

>= 10% change in new PV

(calculated using new terms) and

CV

Derecognize old liability and record

new liability - Gain/Loss in PL

Restructuring

Other than

substantial change

< 10% change in new PV (calculated using new terms)

and CV

Adjust CV of old liability - Gain/Loss

deferred and amortized over remaining term

Hedge Accounting

IAS 39 permits hedge accounting under certain circumstances provided that the hedging relationship is: • formally designated and documented, including the entity's risk management objective and strategy for undertaking the

hedge, identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the entity will assess the hedging instrument's effectiveness; and

• expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk as designated and documented, and effectiveness can be reliably measured.

All derivative contracts with an external counterparty may be designated as hedging instruments except for some written options.

An external non-derivative financial asset or liability may not be designated as a hedging instrument except as a hedge of foreign currency risk.

A proportion of the derivative may be designated as the hedging instrument. Generally, specific cash flows inherent in a derivative cannot be designated in a hedge relationship while other cash flows are excluded. However, the intrinsic value and the time value of an option contract may be separated, with only the intrinsic value being designated. Similarly, the interest element and the spot price of a forward can also be separated, with the spot price being the designated risk.

Hedging Instruments

Hedged Items

A hedged item can be:

• a single recognized asset or liability, firm commitment, highly probable transaction, or a net investment in a foreign operation;

• a group of assets, liabilities, firm commitments, highly probable forecast transactions, or net investments in foreign operations with similar risk characteristics;

• a held-to-maturity investment for foreign currency or credit risk (but not for interest risk or prepayment risk); • a portion of the cash flows or fair value of a financial asset or financial liability; or • a non-financial item for foreign currency risk only or the risk of changes in fair value of the entire item. • in a portfolio hedge of interest rate risk (Macro Hedge) only, a portion of the portfolio of financial assets or financial liabilities

that share the risk being hedged.

Hedge EffectivenessTo qualify for hedge accounting at the inception of a hedge and, at a minimum, at each reporting date, the changes in the fair value or cash flows of the hedged item attributable to the hedged risk must be expected to be highly effective in offsetting the changes in the fair value or cash flows of the hedging instrument on a prospective basis, and on a retrospective basis where actual results are within a range of 80% to 125%.

All hedge ineffectiveness is recognized immediately in the income statement (including ineffectiveness within the 80% to 125% window).

OR

Hedge

Fair value hedge

Gain/Loss on Hedging instrument

in P/L, record derivative

asset/liability for 2nd effect

Gain/Loss on Hedged item in P/L, adjust CV for 2nd

effect

Cash flow hedge

Effective portion of Gain/Loss in OCI

If hedged item subsequently

results in Financial Asset/Financial

Liability

Reclassify OCI gain/loss to P/L

If hedged item subsequently results in Non

Financial Asset/Non Financial Liability

Reclassify OCI gain/loss to P/L

Adjust CV of asset/liability

Ineffective portion of Gain/Loss in P/L

Net investment in Foreign Operation

Same treatment as Cash Flow Hedge

Discontinuation of Hedge Accounting

Hedge accounting must be discontinued prospectively if:

• the hedging instrument expires or is sold, terminated, or exercised;• the hedge no longer meets the hedge accounting criteria - for example it is no longer effective; • for cash flow hedges the forecast transaction is no longer expected to occur; or • the entity revokes the hedge designation.

If hedge accounting ceases for a cash flow hedge relationship because the forecast transaction is no longer expected to occur, gains and losses deferred in equity must be taken to the income statement immediately. If the transaction is still expected to occur and the hedge relationship ceases, the amounts accumulated in equity will be retained in equity until the hedged item affects profit or loss.

Example 1 (Cash Flow Hedge)

A company trades in GBP. It expects to purchase a piece of plant for 1 million euros in one year from 1 May 20X6. In order to offset the risk of increases in the euro rate, the company enters into a forward contract to purchase 1 million euros in 1 year for a fixed amount (GBP 650,000). The forward contract is designated as a cash flow hedge. At inception, the forward contract has a fair value of zero.

At the year end of 31 October 20X6, the euro has appreciated and the value of 1 million euros is GBP 660,000. The machine will still cost 1 million euros so the company concludes that the hedge is 100% effective. Thus the entire change in the fair value of the hedging instrument is recognised directly in reserves.

Example – 2 Fair Value Hedge

A company purchases an equity instrument for $1 million. The instrument is not held for trading and company designated it to be measured at fair value with changes to be recognised through other comprehensive income. The company is exposed to a price risk of the decline in the fair value of the instrument if the market behavior changes.The company purchases put options in order to offset the risk of a decline in fair value. Any decline in the fair value of the instrument should be offset by opposite increases in the fair value of the derivative instrument.

Assuming market prices of shares fall to $960,000. The instrument is classified as FV changes in OCI therefore the decrease in fair value would normally be recorded directly in reserves.However, since the instrument is a hedged item in a fair value hedge, this change in fair value of the instrument will be recognised in profit or loss, if hedge is effective.

At the same time, the company determines that the fair value of the put options has increased by $. 40,000. Since the swap is a derivative, it is measured at fair value with changes in fair value recognised in profit or loss. The changes in fair value of the hedged item and the hedging instrument exactly offset each other: the hedge is 100% effective and the net effect on profit or loss is zero.

TOPICSSum 2014

Winter 2013

Sum 2013

Winter 2012

Sum 2012

Winter 2011

Sum 2011

Winter 2010

Sum 2010

Winter 2009

Sum 2009

Measurement of Financial Asset Q (2)          

Not tested

Not tested

Not tested

   Measurement of Financial Liability         Q (4) ii      Compound Financial Instrument  Q (1)     Q (2) b        Derecognition of Financial Asset         Q (4) i      Extinguishment / Rescheduling of Financial Liability               Q (2)Impairment of Financial Asset Q (3)(b)   Q (5)       Q (6)  Regular way purchase/sale           Q (2)    Hedging   Q (7)   Q (2) a        

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