FINANCIAL INSTRUMENTS By: Associate Professor Dr. GholamReza Zandi

The IASB issued the first standard on presentation and disclosure in IAS 32 Financial Instruments: Presentation and Disclosure. The standards later split into: – IFRS 7 Financial Instruments: Disclosure – IAS 32 Financial Instruments: Presentation 2 IASB

MFRS 139 Financial Instruments: Recognition and Measurement – Establishes principles for recognizing and measuring financial instruments. – Provides guidance on Derecognition, how to assess impairment, determine fair value IASB 3

IAS 32 defines a financial instrument as a contract that results in one entity obtaining a financial asset and another entity taking on an increase in its financial liabilities or its equity. What is Financial Instrument 4

MFRS 132 MFRS 132 defines a financial instrument as ‘any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.’ Examples of primary instruments - receivables, payables and equity securities Examples of derivative instruments - financial options, futures and forwards, interest rate swaps and currency swaps Financial instrument is any contract that gives rise to both: ◦ A financial asset of one entity and ◦ A financial liability or equity instrument of another entity.

THT Ltd raised a loan of RM2million on 1 January 2012 from Bank Of Asia. Outline how the loan should be presented in the financial statements of THT Ltd and Bank of Asia? Example 6

The loan is a financial instrument that gives rise to a financial asset for the Bank, owing at RM2m. For THT Ltd it is a financial liability, as RM2m is owed to the Bank. Loan will be recorded as follows: – Bank Dr Cr Loan receivable (financial assets) 2M Bank 2M – THT Ltd Bank 2M loan (financial liability) 2M Example 7

Equity Instruments Financial Liabilities Financial Assets Classification 8

MFRS 132 – Financial instruments are categorized as Financial assets Financial liabilities Equity instruments MFRS 139, further classifies financial instruments into – Primary instruments – Derivative 9 MFRS

 Any contract that evidences a residual interest in the asset of an entity after deducting all of its liabilities.  Examples of equity are ordinary share, preference shares, share options and warrants. 10 Equity Instruments

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. – A contract that will or may be settled in the entity’s own equity instruments. 11 Financial Asset

 Any liability that is: ◦ A contractual obligation  To deliver cash or another financial asset to another entity or  To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity ◦ 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 deliver a variable number of the entity’s own equity instruments  A derivative that will or may be settled other than by exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments. 12 Financial Liability

Primary instruments All financial instruments other than derivatives – Financial assets at FV through profit or loss – Held to maturity investments – Loans and receivables – Available for sale financial assets Derivatives are contracts that allow entities to speculate or hedge against future changes in the market. 13 MFRS

To require companies to provide disclosures that enable users to evaluate not only the significance of financial instruments for the company’s financial position and performance, but also ‘the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risk. 14 IFRS 7

Example – Requires firms to disclose how its net income (or net loss) for the period would have been affected, if the exchange rate had been higher and lower that it actually was at the reporting date. 15 IFRS 7

Evidence suggest that after the release of IFRS 7 mandated disclosure on currency risk, investors revised their expectation on firm’s exposures, and the stock returns sensitivity to exchange rate changes became consistent with the new information provided. 16 Prior Literature

 It has a rationale only in imperfect capital markets.  Market prices are affected by currency risk, and information about a firm’s currency risk exposure should be taken into account in making decisions.  If sensitivity analysis under IFRS 7 provides useful information to investors about the effect of currency risk on a firm’s value, then investors should react to the new information after it is disclosed in the annual report. 17 Usefulness of Disclosures on Currency Risk

 To 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;  Classification of related interest, dividends, losses and gains;  Circumstances in which financial assets and financial liabilities should be offset. 18 IAS 32 Financial Instruments: Presentation

Presentation of Liabilities & Equity An entity should identify the different components of the instrument and to classify the components as to a financial asset, financial liability or equity on initial recognition based on: – the substance of the contractual arrangement (not merely their legal form); and – the definitions of financial liabilities, financial assets or equity instruments.

Substance versus Legal Form ‘Puttable’ Instruments A financial instrument that gives the holder the right to return the instrument to the issuer for cash or another financial asset (a ‘puttable instrument’) is a financial liability. Examples of ‘puttable’ instruments which give the holders the options to return the instruments to the issuer are unit trusts, open ended mutual funds and ownership units in co-operatives.

Compound/Hybrid Financial Instruments  They are classified by the issuer according to the substance of contractual arrangement and the definitions of a financial liability and an equity instrument.  Their components are classified separately as financial liabilities, financial assets or equity instruments.  For example, a bond that grants an option to the holder to convert it into a fixed number of ordinary shares is a compound instrument and it comprises two components: a financial liability (a contractual agreement to deliver cash or other financial asset); and an equity instrument (an option to convert into ordinary shares).

Treasury Shares  A company may repurchase its issued equity shares provided not all the shares are repurchased. This is termed as share buy back.  The company may cancel the shares or hold them. It is an option.  If it cancels the shares bought back, then it is required to follow the legal requirements as set out in the Companies Act 1965 regarding cancellation of shares. The companies Act 1965 requires the company to transfer to the capital redemption reserve an amount equal to the nominal capital cancelled.  On the other hand, the shares may not be cancelled but held to be reissued at a later date. Equity shares bought back but not cancelled are termed treasury shares. The amount paid for the redemption is held in a separate account. In the SOFP, the treasury shares should be deducted from equity.  No gain or loss should be recognised in income statement on the purchase, sale, issue or cancellation of the entity’s own equity instruments. Consideration paid or received should be recognised directly in equity.

Interest, Dividends, Losses and Gains The accounting treatment and presentation of interest, dividends, losses and gains depend on whether the items are related to liability or equity. It they relate to financial liability, they should be reported in the income statement as expense or income such as interest on bonds. If they relate to an equity instrument, they should be recorded directly to the statement of changes in equity.

Offsetting a Financial Asset & a Financial Liability Financial assets and liabilities are presented separately. However, a financial asset and liability shall be offset and the net amount presented in the SOFP when an entity has a legally enforceable right of offset and intends to settle on a net basis or to realize the asset and settle the liability simultaneously. Offsetting does not amount to Derecognition.

The End