FINANCIAL INSTRUMENTS: PRESENTATION MFRS 132 FINANCIAL INSTRUMENTS: PRESENTATION

Background of Reporting Standards in Malaysia 4 2008 - FRF and MASB announced plan to fully converge to IFRS beginning 1 January 2012 3 1997 - FRF and MASB started issuing MASB standards and later changed name to FRS (2005) 2 1978 MACPA started adopting IAS and developing MAS 1 Before 1978 - Companies Act 1965

Background of MFRS Before 1 January 2006, it was the MASB Framework for all companies; Effective January 2006, Financial Reporting Standards (FRS) Framework for all companies; Effective January 2006, FRS Framework for all companies began reporting to the Securities Commission (SC) and Bank Negara Malaysia (BNM), and PERS (Private Entity Reporting Standards) Framework went into effect for private entities; On 19 November 2011, the Malaysian Accounting Standards Board (MASB) announced the implementation of the Malaysian Financial Reporting Standards (MFRS) Framework to achieve their pledge for full convergence.

Background of MFRS Effective 1 January 2012, the existing FRS framework will be replaced by the MFRS framework. The MFRS framework will effectively adopt the IFRS framework by the IASB. This means that the standards issued by the MASB will now be simultaneous with the IASB.

MFRS 132 Learning Outcomes After going through this lecture, students should be able to understand: Financial instruments (FI). Financial asset (FA). Financial liabilities (FL) and equity. Presentation of liabilities and equity. Contingent settlement provision. Compound financial instruments. Treasury shares. Interest, dividend, gains & losses. Offsetting a FA and a FL.

Introduction to Financial Instruments Arguably one of the most complex subjects in financial accounting and reporting. Simply – a means of raising finance and includes ‘everyday’ loans. In practice – wide ranging, extremely complex financial arrangements. Dynamics of the international financial markets creates a wide range of financial instruments.

Introduction to Financial Instruments Financial instruments include both (as further classified in MFRS139): Primary instruments such as receivables, payables and equity securities; and Derivative instruments such as financial options, futures and forwards, interest rate swaps and currency swaps.

Introduction to Financial Instruments Financial instruments comprise a mixture of on and off financial statements. Financial instruments can significantly contribute to risks that an enterprise faces. Separate standards dealing with how financial instruments should be presented, recognised, measured and disclosed.

The Relevant MFRSs MFRS 132 Financial Instruments: Presentation MFRS 139 Financial Instruments: Recognition and Measurement MFRS 7 Financial Instruments: Disclosures MFRS 9 Financial Instruments 15/4/2019

Background of the MFRSs for Financial Instruments IASC issued ED 40 and ED 48 1995 IAS 32 was issued 1997 IASC published a comprehensive discussion paper, Accounting for FA and FL, proposing FV accounting model 1998 ED 68 was issued followed by the finalized IAS 39 2001 IASB adopted IAS 32 2003 IAS 32 was revised 2005 IAS 32 was divided into two parts, 1st part: the revised IAS 32 (changed name), and 2nd part: IFRS 7 2008 IASB undertook a project to replace IAS 39 (three phases) 2009 IFRS 9 (2009) – classification and measurement, was issued 2010 IFRS 9 (2010) revised version – include impairment methodology 2014 IFRS 9 (2014) complete version – include impairment methodology and hedge accounting

Introduction MFRS 132 Objective Scope Definition Presentation

Objective “The objective of this Standard is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and liabilities” [MFRS 132 para 2].

1 2 3 4 Objective The standard: establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. applies to the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments; the classification of related interest, dividends, losses and gains; the circumstances in which financial assets and financial liabilities should be offset. Key words: 4 , four stages, movement, timeline, years, period, ahead, steps, aspects

Scope “This Standard shall be applied to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements” [MFRS 132 para 8].

FI - Definition “A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity” [MFRS 132 para 11]. *Note: Rights and obligations

FA - Definition Financial asset is any asset that is: cash, an equity instrument of another entity, a contractual right: to receive cash or another financial asset from another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or

FA - Definition a contract that will or may be settled in the entity’s own equity instruments and is: 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 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. For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments. MFRS 132 para 11(a)-(d)

FA - Definition Examples: trade receivables, loans receivable, investment in shares and bonds of another entity, investment in subsidiaries and bill receivable. Pre-paid expenses for which economic benefits will be in the form of goods or services are not a financial asset.

FL - Definition Financial liability is any liability that is: a contractual obligation: to deliver cash or another financial asset to another entity; or to exchange financial asset or liability under conditions that are potentially unfavourable to the entity; A contract that will or may be settled in the entity’s own equity instruments… MFRS 132 para 11(a)&(b)

FL - Definition Examples: trade payables, borrowing, debentures, bonds and redeemable preferences shares. Deferred revenue and most warranty obligations are not financial liabilities as there will be an obligation to provide services or goods rather than an obligation to deliver cash. Incomes taxes are not a financial liability as there is no contract obligation.

EI - Definition “An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities” [MFRS 132 para 11]. Examples: Shares in issue – ordinary and preference shares, equity component in compound instruments, share options, warrants, retained earnings.

FI - Summary FA FL EI cash equity instrument of another entity contractual right to receive cash or another financial asset or to exchange financial assets or liabilities under potentially favourable conditions certain contracts settled in the entity’s own equity contractual obligation to deliver cash or another financial asset or to exchange financial asset or liabilities under potentially unfavourable conditions certain contracts settled in the entity’s own equity Contract evidencing a residual interest in the assets of an entity after deducting all of its liabilities

Puttable Instrument – Definition “A puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder” [MFRS 132 para 11]. However, the standards allow puttable financial instruments of co-operatives, trust funds and similar entities that are financial liabilities to be classified as equity instruments provided the specified conditions are met.

Fair Value – Definition Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction [MFRS 132 para 11].

Presentation of FL and EI A financial instrument should be classified as either an equity instrument or a financial liability according to the substance of the contract, not its legal form; and the definitions of FL and EI. An entity must make this decision at the time the instrument is initially recognised and the classification cannot be subsequently revised based on changed circumstances. MFRS 132 para 15

Presentation of FL and EI – Classification Principle In determining whether a financial instrument is a financial liability or an equity instrument, the instrument is an equity instrument if, and only if, both conditions (a) and (b) below are met [MFRS 132 IN6 & MFRS 132 para 16 (a) & (b)]: (a) The instrument includes no contractual obligation: (i) to deliver cash or other financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer.

Presentation of FL and EI – Classification Principle If the instrument will or may be settled in the issuer’s own equity instruments, it is: (i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or (ii) a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. For this purpose, the issuer’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the issuer’s own equity instruments.

Presentation of FL and EI – Example If an enterprise issues preference shares that pay a fixed rate of dividend and that have a mandatory redemption feature (for example, must be repaid on a specified date and amount in the future), the substance is that they are a contractual obligation to deliver cash and, therefore, should be recognised as a liability. In contrast, if the preference shares do not have a fixed maturity date, and the issuer does not have a contractual obligation to make any payment, then the preference shares would be treated as part of equity. For example: X Limited has 200,000 10% RM1 preference shares in issue. The shares are redeemable in five years at a premium of 25 cent; Top Limited entered into a zero coupon loan (i.e. interest and principal repayments deferred until maturity) for RM400,000. No interest is payable during the term of the loan but the loan is repayable after 5 years at RM440,000.

Contingent Settlement Provision If the manner of settlement of the financial instruments depends on the outcome of uncertain future events which are beyond the control of both the issuer and the holder, such as a change in stock market index, consumer price index, interest rate or taxation requirement, these instruments should be classified as liabilities unless the possibility of settlement in cash is remote [MFRS 132 para 25].

Settlement Options When a derivative financial instrument gives one party a choice over how it is settled (e.g. the issuer or the holder can choose settlement net in cash or by exchanging shares for cash), it is a financial asset or a financial liability unless all of the settlement alternatives would result in it being an equity instrument. MFRS 132 para 26

Compound Financial Instruments MFRS 132 para 28 provides that the issuers of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial asset or equity instruments in accordance with MFRS 132 para 15. Split made at issuance and cannot be revised.

Compound Financial Instruments - Example Tilt SB issued the following compound financial instrument at par on 31 December 2012: two million 50 cent 3% convertible bonds 2018. The value of two million 50 cent 3% convertible bonds 2018 without the conversion rights was estimated to be RM960,000 on 31 December 2012. Requirement Show the amounts that should be included in the financial statements of Tilt SB for the year ended 31 December 2012 in respect of the above transactions. Solution RM Total amount raised at issue (2m x 50c) 1,000,000 Allocated to liability (FV of bond without rights) 960,000 Allocated to equity 40,000 Classification is made at issuance.

Treasury Shares If an entity reacquires its own equity instruments, those instruments (‘treasury shares’) shall be deducted from equity. No gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments. Such treasury shares may be acquired and held by the entity or by other members of the consolidated group. Consideration paid or received shall be recognised directly in equity. MFRS 132 para 33

Treasury Shares - Example An entity entered into a share buyback scheme. It reacquired 10,000 RM1.00 ordinary shares for RM2.00 cash per share. The shares had originally been issued for RM1.20 per share. The entity should record the reacquired shares as a debit entry of RM20,000 in equity. The original share capital and share premium amounts of RM10,000 and RM2,000 remain unchanged.

Perpetual debt Irredeemable debt accounted for as financial liability and not equity. Due to the obligation to pay interest to perpetuity. Value of debt equal to present value of future interest payment. MFRS 132 AG6

Interest, Dividends, Losses and Gains Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognised as income or expense in profit or loss. Distributions to holders of an equity instrument shall be debited by the entity directly to equity, net of any related income tax benefit. Transaction costs of an equity transaction shall be accounted for as a deduction from equity, net of any related income tax benefit. MFRS 132 para 35

Offsetting a FA and a FL MFRS 132 para 42 provides that a FA and a FL shall be offset and the net amount presented in the statement of financial position when, and only when, an entity: (a) Currently has a legally enforceable right to set off the recognized amounts; and (b) Intends either to settle on a net basis, or to realize the asset and settle the liability simultaneously.

Offsetting a FA and a FL In accounting for a transfer of a financial asset that does not qualify for derecognition, the entity shall not offset the transferred asset and the associated liability [MFRS 139 para 36].

Offsetting a FA and a FL MFRS 132 para 49 further provides that offsetting is usually inappropriate when: (a) Several different FI are used to emulate the features of a single FI (a ‘synthetic instrument’); (b) FA & FL arise from FI having the same primary risk exposure but involve different counterparties; (c) Financial or other assets are pledged collateral for nonrecourse FL;

Offsetting a FA and a FL FA are aside in trust by a debtor for the purpose of charging an obligation without those assets having been accepted by the creditor in settlement of the obligation; or (e) Obligations incurred as a result of events giving rise to losses are expected to be recovered from a third party by virtue of claim made under an insurance contract.

Conclusion MFRS 132 is one of the three standards addressing the issue of FI. MFRS 132 clarifies the classification of equity and liability, treasury shares, and offsetting of assets and liabilities. It also specifies the presentation rules of FI.

Example 1 Explain whether each of the following meet the definition of a financial instrument: Issue of ordinary share capital Issue of debt Sale of goods on credit Purchase of goods on credit

Solution to Example 1 (a) Issue of ordinary share capital represents an equity instrument since the shareholders own a financial asset and the company has an equity instrument in the form of new share capital. (b) Issue of debt creates a contractual obligation between the company and the lender for the debt to be repaid in the future. Therefore the company has a financial liability and the lender has a financial asset. (c) Sale of goods on credit creates a contractual obligation between the customer and the company. The customer has a financial liability and the company has a financial asset. (d) Purchase of goods on credit creates a contractual obligation on the part of the company to pay for the goods. Therefore the company has a financial liability and the supplier has a financial asset.

Example 2 A note payable in government bonds gives the holder the contractual right to receive and the issuer the contractual obligation to deliver government bonds, not cash. Is note payable a financial asset in the hands of the holder, and financial liability in the hands of the issuer?

Solution to Example 2 In one type of financial instrument the economic benefit to be received or given up is a financial asset other than cash. In the given example, the bonds are financial assets because they represent obligations of the issuing government to pay cash. The note is, therefore, a financial asset of the note holder and a financial liability of the note issuer.

Example 3 Is advance payment to acquire debentures of another entity or Government T-Bills or equity shares / preferences of another entity is a financial asset?

Solution to Example 3 Yes. Under Paragraph 11 ( c) (ii) of MFRS 132 , advance payment signifies a contractual right of the entity to receive a financial asset, so it is a financial asset.

Example 4 Under a futures contract X Ltd. has entered into 4 lots of Feb 2013 Futures contract in MCX to buy 100 MT ( lot size 25 MT) of Steelflat at an agreed price of RM 6,500 per MT. There is a practice of settling the transaction net based on settlement price of commodity exchange futures. On 31 December, 2012 X Ltd. finalizes 3rd quarter accounts. As on that date settlement price is RM 6,600 per MT. Should this contract be classified as financial asset?

Solution to Example 4 A commodity derivative contract that contains a net settlement clause is a financial instrument. Derivative with a positive value is financial asset. Under the contract, the carrying amount of the financial asset was Rm 10,000 [100 × (6600-6500)]. [11d(ii)] [42b]

Example 5 A Ltd. issues 1,000 shares with a par value of RM10 each. The holder of the shares has the option to require the company to redeem the shares at par at any given time. Whether these shares are classified as equity or liability? How would the answer be different if the entity has the option to redeem the shares?

Solution to Example 5 [AG25-26] These shares are classified as liabilities unless classified as puttable instruments as equity under Paragraphs 16A & 16B, MFRS 132. This is because A Ltd. does not have the ability to avoid the obligation to redeem the shares for cash should the holder exercise his option to redeem the shares. If the option to redeem the entity's shares had instead been at the discretion of the issuer, the shares would have been classified as equity. In this case, the issuer has a right to pay cash to buy back the shares but no obligation to do so. [AG25-26]

Example 6 B Ltd. issues preference shares with a par value of RM 100 each. The preference shares are non-redeemable but require the entity to make annual dividend payments @ 9 % on the par value. Are the preference shares classified as equity?

Solution to Example 6 No. Paragraph AG 26 , MFRS 132 explains that non-redeemable preference shares are classified as equity if the dividend is optional but cumulative or non-cumulative. In the given case, dividend payment is mandatory so the preference shares are classified as liability.

Example 7 X Ltd. issues 1,000,000 perpetual shares of RM 100 each on which it is liable to pay a 10% of its profits in each annual accounting period. Profit for this purpose means PAT of the company. Are these shares classified as equity?

Solution to Example 7 No. An instrument which contains an obligation to pay mandatory payments either on the amount of par value of shares or as a percentage of profit is classified as a financial liability.

Example 8 Akash Investment Ltd. invested in 8% Perpetual debt of face value RM10,000 issued by Delhi Auto Ltd. How should this instrument be evaluated as an item of financial asset ?  

Solution to Example 8 Analysis : This instrument gives a contractual right to the holder ( Akash Investment) to get a perpetuity of RM800. It is measured in terms of present value applying current market yield. Assuming current market yield of that type of perpetual debt instrument is 7% , then it is valued at - RM800 ------------- = RM11,429. 7%   Similarly for Delhi Auto Ltd. it is a financial liability. [AG16]

Example 9 X Ltd. has issued 1,000,000 non-redeemable preference shares. The instruments contain a condition that the issuer has to transfer a property to the holder of the instrument if it fails to make dividend payments. Should the instrument be classified as an equity or a financial liability?

Solution to Example 9 The instrument contains a contractual obligation to pay dividend. As per Paragraph 20(a) , MFRS 132 if the entity can avoid a transfer of cash or another financial asset only by settling the non-financial obligation, the financial instrument is a financial liability. In the given case, obligation to settle by transfer of property creates an indirect obligation to make the dividend payments, and the instrument is therefore classified as a liability.

Example 10 Vision Ltd issued 100 million 5% convertible bonds at par on 1st January 2013. the debentures can either be converted into 50 ordinary shares of sh 2 each for every sh 100 of bond, or redeemed at par any time from 1st January 2020. the interest rate of similar bonds without conversion option is 6% Explain how to use split accounting approach

Solution to Example 10 Present value of redemption payment 74,726 Present value of coupon payment 21,062 Value of debt 95,788 Value of equity (residual) Proceed on issue 100,000 Less value of debt component 95,788 Equity (share premium) 4,212

Exercises A bank advances an entity a five-year loan. The bank also provided the entity with an overdraft facility for a number of years. Entity A owns preference shares in entity B. The preference shares entitle entity A to dividends, but not to any voting rights. An entity (the purchaser) buys goods from a supplier on 60 days’ credit. Entity A purchases a subsidiary from entity B. Under the agreement, entity A pays the purchase price in two instalments—RM5 million(1) upfront and a further payment (which is not a contingent payment) of RM5 million two years later. An entity has a present obligation in respect of income tax due for the prior year.

Exercises Every year for the past twenty years a catering entity has paid RM50,000 towards the costs of the carnival in the village in which the entity operates. The entity is well known as the main sponsor of the annual event and its advertisements include reference to its status as main sponsor of the village carnival. The villagers now expect the entity to pay RM50,000 to cover the costs of the carnival this year. 7. In a lawsuit brought against an entity, a group of people are collectively seeking compensation for damages to their health as a result of contamination to the nearby land believed to be caused by waste from that entity’s production process. It is doubtful whether the entity is the source of the contamination since many entities operate in the same area producing similar waste and it is unclear who is the source of the contamination.

Exercises An entity is fined for contravening three separate legislative requirements: (i) for the late payment of income tax; (ii) for failing to submit its company accounts on time; and (iii) for false claims made in advertisements for its products. An entity has inventories, property plant and equipment, investment property, acquired patents and licences in its statement of financial position. At the end of the reporting period an entity has an asset for the prepayment of three months of rent on its office building. 11. An entity sells goods to customers and provides a one-year guarantee to repair or replace any defective products.

Exercises 12. An entity has entered into a construction contract to build a building for a customer. The entity has an asset in its statement of financial position showing the gross amount due from customers for contract work. An entity leases a machine from a machine manufacturing entity under a five-year operating lease. An entity buys gold bullion as an investment. 15. An entity is both the policyholder and the beneficiary in a life insurance contract (also known as life assurance). The contract requires the insurer to pay to the entity a sum of money upon the occurrence of the death or terminal illness of the owner-manager of the entity. In accordance with the contract, the entity is required to pay a stipulated amount annually until the insured event (death or illness) occurs.

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