Accounting for financial instruments Chapter 15 Accounting for financial instruments Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Learning objectives Understand what a financial instrument is Be able to describe various types of financial instruments Understand the difference between a primary financial instrument and a derivative financial instrument Understand that some derivative financial instruments can significantly increase the risk exposure of an organisation, and so appreciate the necessity for full disclosure in relation to such instruments Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Learning objectives (cont.) Understand what a compound financial instrument is and how the debt and equity components of a compound equity instrument are to be determined Understand the requirements of AASB 7 - ‘Financial Instruments: Disclosure’; AASB 132 - ‘Financial Instruments: Presentation’ and AASB 139 - ‘Financial Instruments: Recognition and Measurement’ Be able to provide accounting entries for various types of futures contracts, options, swap agreements and compound financial instruments Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Relevant accounting standards There are three standards: AASB 7 ‘Financial Instruments: Disclosure’ AASB 132 ‘Financial Instruments: Presentation’; and AASB 139 ‘Financial Instruments: Recognition and Measurement’ Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Financial instruments defined A financial instrument (AASB 132) is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity A financial asset (AASB 132) is cash; or a contractual right to receive cash or another financial asset from another entity; or a contractual right to exchange financial instruments with another entity under conditions that are potentially favourable; or an equity instrument of another entity Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Financial instruments defined (cont.) A financial liability (AASB 132) is any liability that is a contractual obligation to deliver cash or another financial asset to another entity; or to exchange financial assets or liabilities with another entity under conditions that are potentially unfavourable; or a contract that is a derivative; or a non-derivative An equity instrument (AASB 132) is any contract that evidences a residual interest in the assets of another entity after deduction of all its liabilities Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Financial instruments defined (cont.) Central to the definition is whether or not a ‘contractual obligation’ exists if there is no contractual obligation to deliver cash or another financial asset, or to exchange another financial instrument under conditions that are potentially unfavourable, it is considered to be an equity instrument what does ‘unfavourable’ mean in this context? – see Worked Example 15.1 (p. 507) which shows how the issue of share options creates a financial asset in the accounts of the holder of the options, and a financial liability in the accounts of the issuer in the context of the issue of options, the likelihood of the option being exercised does not impact on its classification as a financial liability Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Financial instruments defined (cont.) Examples of financial instruments cash at bank bank overdrafts term deposits trade receivables and payables investments options forward foreign exchange agreements foreign currency swaps Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Financial instruments defined (cont.) Primary financial instruments include receivables, payables and equity securities such as ordinary shares – accounting treatment fairly straightforward Derivative financial instruments create rights and obligations with the effect of transferring one or more of the financial risks inherent in an underlying primary financial instrument include financial options, futures, forward contracts and interest rate and currency swaps Refer to Worked Example 15.2 (p. 510) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Debt versus equity components of financial instruments The issuer of a financial instrument must determine whether to disclose it as a liability or equity (AASB 132) they are required to consider economic substance rather than just the legal form Critical feature in differentiating financial liability from equity is the existence of a contractual obligation on the part of one entity either to deliver cash or another financial asset to, or to exchange another financial instrument Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Debt versus equity components of financial instruments (cont.) Preference shares if there is an option to redeem the shares for cash, should be debt rather than equity when distributions to shareholders are at the issuer’s discretion, shares are equity If classified as debt, then periodic payments are classified as interest expenses, which will affect profits Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Debt versus equity components of financial instruments (cont.) Convertible notes debt giving the holder the right to convert securities into the issuer’s ordinary shares often classified as compound financial instruments, containing both a financial liability and equity component debt and equity components to be accounted for and disclosed separately Interest can be treated as part of the cost of an asset under construction Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Debt versus equity components of financial instruments (cont.) Instruments cannot be reclassified after initial recognition unless their substance is altered by a transaction or other specific action by the issuer (AASB 132) The AASB Framework allows reclassifications based on revised probabilities (however, accounting standards take precedence) Determine fair value of liability component and equity component as the residual Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Measurement of financial instruments According to AASB 139 financial instruments are generally to be measured at fair value, with some exceptions Categories of financial instruments (AASB 139) financial asset or financial liability at fair value through profit and loss; held-to-maturity investments; loans and receivables; available-for-sale financial assets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Financial asset or financial liability at fair value through profit or loss Financial asset or financial liability at fair value through profit or loss if (AASB 139) classified as held for trading; or upon initial recognition it is designated by entity as at fair value through profit or loss periodic adjustments go to profit or loss Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Available-for-sale financial assets Includes all financial assets that don’t fall into other categories Equity investments to be measured at fair value Changes in fair value recognised in equity until financial asset is derecognised Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Loans and receivables and held-to-maturity investments To be measured at amortised cost using the effective-interest method If an impairment loss has been incurred, amount of loss is calculated as (AASB 139) the difference between asset’s carrying amount and present value of estimated future cash flows with; carrying amount to be reduced directly or through an allowance account loss to be recognised in profit or loss Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Other financial liabilities To be recognised at amortised cost using effective-interest method subsequent to initial measurement (AASB 139) Refer to Worked Example 15.3 (p. 521) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Derivative financial instruments Can include futures contracts options contracts interest rate swaps foreign currency swaps forward-rate contracts To be recognised initially at fair value (AASB 139) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Derivatives used within a hedging arrangement Derivatives often used to hedge gains or losses in future in relation to other assets or liabilities Hedge contract arrangement with another party in which that party accepts the risks associated with changing commodity prices or exchange rates Three principal types of hedges (AASB 139) fair value hedges cash-flow hedges hedges of net investments in foreign operations Need to differentiate between hedged item and hedging instrument Refer to Worked Example 15.4 (p. 522) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Derivatives used within a hedging arrangement (cont.) Fair value hedge used to hedge the value of particular assets or liabilities Cash-flow hedge used to hedge a future expected cash flow Unless certain strict requirements are satisfied (AASB 139) any gain or loss on hedging instrument to be taken to profit or loss Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Derivatives used within a hedging arrangement (cont.) Tests for hedge effectiveness at inception of hedge and throughout its life, hedge must be ‘highly effective’ as measured each financial period, hedge is deemed to be highly effective so that actual results are between 80 and 125% Fair value hedge both hedged item and hedging instrument to be measured at fair value any gains or losses to be included as part of profit or loss Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Derivatives used within a hedging arrangement (cont.) Cash-flow hedge gain or loss on measuring hedged item at fair value is to be part of period’s profit or loss gain or loss on hedging instrument initially transferred to equity, then transferred to income statement to offset gains or losses on hedged item Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Futures contracts A contract to buy or sell an agreed quantity of a particular item, at an agreed price, on a specific date Buy or sell price determined on date contract entered into First futures contracts introduced in 1960 in Australia for greasy wool Majority of trading volume now relates to financial futures result in the ultimate transfer of cash or another financial instrument Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Futures contracts (cont.) Financial futures currently traded 90-day bank bill futures 3-year bond futures 10-year bond futures share price index futures (SPI futures) futures for shares in specific companies Huge losses (or gains) can be made on the futures market Refer to Worked Examples 15.5 and 15.6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Futures contracts (cont.) Share price index (SPI) futures based on e.g. market prices of top 200 companies and on performance of top 50 companies directly related to the All Ordinaries SPI may be used for hedging purposes or speculation Refer to Worked Example 15.7 (p. 529) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for SPI futures To make a percentage deposit with the futures broker Debit Deposit on SPI futures Credit Cash at bank To ‘mark to market’ the value of the organisation’s share portfolio Debit Loss on share portfolio Credit Share portfolio To credit gains to the initial deposit held by the futures broker Debit Deposit held by broker Credit Gain on futures contract Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for SPI futures (cont.) If shares are sold and futures contract is closed out Debit Cash Debit Loss on share portfolio Credit Share portfolio Debit Deposit held by broker Credit Gain on futures contract Debit Cash at bank Credit Deposit held by broker Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for currency futures Refer to Worked Example 15.8 To record sale at spot rate Debit Accounts receivable Debit Cost of goods sold Credit Sales revenue Credit Inventory To record deposit made with futures broker Debit Deposit on futures contract Credit Cash at bank Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for currency futures (cont.) To record receipt from overseas purchaser Debit Cash at bank Debit Loss on foreign exchange Credit Accounts receivable To record gain on futures contract Debit Deposit with futures broker Credit Gain on futures contract (equity) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for currency futures (cont.) To transfer gain from equity to offset loss on hedged item Debit Gain on futures contract (equity) Credit Gain on futures contract (in profit or loss) To record receipt of original deposit and gains on contract Debit Cash at bank Credit Deposit with futures broker Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Options Put options Call options give their holder the right to sell an asset, at a specified exercise price, on or before a specified date value of option depends on market price of underlying security Call options give their holder the right to buy an asset, at a specified exercise price, on or before a specified date Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Options (cont.) Exercise price the price the option holder will pay to buy a company’s shares Once exercise price is determined, it remains fixed, regardless of variations in market price of shares When an option is acquired on the ASX, an amount is paid for it The holder of the option has the right to exercise the option, but typically does not have to do so Options are to measured at fair value, with changes included as part of profit or loss Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for options Refer to Worked Example 15.9 (p. 535) To record investment in share options Debit Investment in share options Credit Cash at bank To value share options at fair value Credit Profit on share options Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Swaps Swap agreement Commonly used swaps an agreement between borrowers to exchange aspects of their respective loan obligations Commonly used swaps interest rate swaps foreign currency swaps Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Swaps (cont.) Foreign currency swaps obligation relating to a loan in one currency is swapped for that of a loan in another currency used when entity has receivables and payables both denominated in a different foreign currency used to hedge against effects of changes in exchange rates entity seeks another entity that is prepared to swap its foreign currency loans for the entity’s domestic loans primary borrower still has commitment to primary lender should the other party to the swap default on the arrangement Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for foreign currency swaps Refer to Worked Examples 15.10 and 15.11 To recognise initial loan received Debit Cash Credit Foreign loan To recognise the swap Debit Foreign currency receivable Credit Australian loan To recognise loss on the foreign loan Debit Foreign exchange loss Credit Foreign loan To recognise gain on the receivable Credit Foreign exchange gain Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for foreign currency swaps (cont.) To recognise payment made to foreign company Debit Interest expense Credit Cash To recognise payment made to other company Credit Cash To recognise domestic loan taken out Debit Cash Credit Loan To recognise the swap Debit Loan receivable Credit Foreign currency payable Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for foreign currency swaps (cont.) To recognise the loss on the foreign loan Debit Foreign exchange loss Credit Foreign currency payable To recognise interest payment on domestic loan Debit Interest expense Credit Cash To recognise adjustment to interest expense Debit Cash Credit Interest expense Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Swaps (cont.) Interest rate swaps Refer to Worked Example 15.12 one party exchanges interest payments of a specified amount with another party generally involves swapping variable or floating interest rate payments for a fixed interest rate obligation for a swap to proceed both parties need to receive benefits in the form of a reduction in total interest payments Refer to Worked Example 15.12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Compound instruments Contain both a financial liability and an equity component Include convertible notes similar to convertible bonds, except less formal in the absence of a detailed deed AASB 132 requires equity component to be fair value of the whole instrument less fair value of the liability component. That is, the equity component is the residual measure The AASB Framework considers perceived probabilities of conversion differently from AASB 132 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for compound instruments Refer to Worked Example 15.13 (p. 542) To record the issue of the convertible bonds Debit Cash at bank Credit Convertible bonds (liability) Credit Convertible bonds (equity) The liability component is determined by calculating the present value of the future cash flows at the market’s required rate of return based on “instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option” (AASB 132) To recognise interest expense Debit Interest expense Credit Cash Interest expense equals the present value of the opening liability multiplied by the market rate if interest Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Journal entries for compound instruments (cont.) If option holders elect to convert options to ordinary shares To recognise interest expense Debit Interest expense Credit Cash Credit Convertible bonds (liability) To recognise conversion of bonds into shares Debit Convertible bonds (liability) Debit Convertible bonds (equity) Credit Share capital Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Disclosure requirements Large number of detailed disclosure requirements in AASB 7 a direct consequence of large losses incurred by many organisations Purpose of AASB 7’s disclosure requirements to enhance understanding of significance of financial instruments; and to assist in assessing amounts, timing and certainty of cash flows Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Disclosure requirements (cont.) Numerous disclosure requirements in AASB 7 – best way to appreciate the extensive nature of the disclosures is to review the standard Interesting to see that there are various disclosures related the ‘risks’ associated with financial instruments (par. 32 – 42) Risk to be disclosed relate to: credit risk (the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation) liquidity risk (the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities) market risk (the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan

Summary The chapter addresses issues associated with financial instruments ‘Financial instruments’ includes a wide range of items can be classified as primary or derivative AASB 7 provides many disclosure requirements for financial instruments AASB 132 provides guidance for determining whether a financial instrument is a financial liability or an equity instrument AASB 139 provides requirements for recognition and measurement of financial instruments Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan