Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-1 Chapter 14 Accounting for financial instruments

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-2 Objectives of this lecture Understand what a financial instrument is Know what constitutes a financial asset, a financial liability and an equity instrument Understand the difference between a primary financial instrument and a derivative financial instrument Understand the factors that determine whether a financial instrument shall be presented as debt or equity in the financial statements of the issuing entity Understand how to measure a financial instrument

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-3 Objectives (cont.) 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 Understand what a compound financial instrument is and how the debt and equity components of a compound equity instrument are to be determined Understand what a ‘set-off’ represents, when it is permitted and what benefits it generates Be able to account for various types of futures contracts, options, swap agreements and compound financial instruments

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-4 Relevant accounting standards There are four standards that are of direct importance to this lecture, these being: 1.AASB 7 Financial Instruments: Disclosure 2.AASB 9 Financial Instruments 3.AASB 132 Financial Instruments: Presentation 4.AASB 139 Financial Instruments: Recognition and Measurement

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-5 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) would include: –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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-6 Financial instruments defined (cont.) A financial liability (AASB 132) would include: –any liability that is a contractual obligation –a contract that will or may be settled in the entity’s own equity instruments and 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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-7 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 –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 Refer to Worked Example 14.1, p. 463—Share options and determining a financial asset or a financial liability exists

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-8 Financial instruments defined (cont.) Physical assets, leased assets, and intangible assets are not financial assets. Control of such physical and intangible assets creates an opportunity to generate an inflow of cash or another financial asset, but it does not give rise to a present right to receive cash or another financial asset.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 14-9 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 14.2, p. 464—Derivative financial instrument

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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) Differentiating financial liability from equity If an instrument will or may be settled in the issuer’s own equity instruments, and there is an obligation for the issuer to deliver a variable number of its own equity instruments then this is a financial liability For example, consider the example given on the next slide

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Example of a financial liability Bombora Ltd has entered an agreement to provide Rocky Outcrop Ltd with $1 million of shares in Bombora Ltd (based on market value at the time of future payment). If the price of the shares was $2.50 at the time the instrument was created, Bombora Ltd would have to provide shares if the market price remains static. However, if the market price falls to $2.00 Bombora Ltd would have to provide shares. The risk remains with Bombora Ltd. Rocky Outcrop Ltd will receive $1 million in shares regardless of the market price. Given these conditions the instrument that provides that Bombora Ltd will transfer shares to Rocky Outcrop Ltd a variable number of its own equity instruments would be considered to be a financial liability from Bombora Ltd’s perspective. From Rocky Outcrop Ltd’s perspective, the financial instrument is a financial asset.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Debt versus equity components of financial instruments (cont.) Preference shares –If there is an option for the holder to redeem the shares for cash, should be debt from the issuer’s perspective rather than equity –When distributions to shareholders are at the issuer’s discretion, shares are equity 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 from the perspective of the issuer –Debt and equity components to be accounted for and disclosed separately

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Debt versus equity components of financial instruments (cont.) When their substance is altered by a transaction or other specific action by the issuer (AASB 132) Reclassifications based on revised probabilities allowed by the Conceptual Framework (but, accounting standards take precedence over Conceptual Framework) The issuer of a compound financial instrument is to determine fair value of the liability component and the equity component is the residual

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Set-off of assets and liabilities Set-off defined AASB 132 Financial Instruments : Presentation requirements A right of set-off Performing a set-off Refer to Worked Example 14.3, p. 471—Setting off debt

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Recognition and measurement of financial instruments AASB 9 requires an entity to recognise a financial instrument in its statement of financial position at the point in time: –‘when the entity becomes party to the contractual provisions of the instrument’ According to AASB 9: –financial instruments are generally to be measured at fair value, with some exceptions

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Measurement of financial instruments Fair value is defined in AASB 9 in a manner consistent with other standards. The definition of fair value changed in September 2011 as a result of the release of AASB 13 Fair Value Measurement. AASB 13 fair value is now defined as: –the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Measurement of financial assets following initial recognition Following initial recognition—which must be at fair value— financial assets shall subsequently either be measured at fair value or at amortised cost. Classification is made at the time the financial asset is initially recognised AASB 9 requires that the use of either measurement basis (fair value, or amortised cost) will be dependent on both: (a) the entity’s business model for managing the financial assets, and (b) the contractual cash flow characteristics of the financial asset. AASB 9 requirements for amortised cost as the basis of measurement subsequent to acquisition.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Financial asset measurement If an entity holds the assets to realise fair value changes then it should measure the asset at fair value. If the asset is held to receive periodic interest payments and principal repayment then the asset shall be recorded at amortised cost. Instruments that are held for trading would be measured at fair value as they are not held to collect the contractual cash flows of the instrument. Refer to Worked Example 14.4, p. 475—Determining the amortised cost of a financial asset.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Gains on financial assets measured at fair value AASB 9 requires that a gain or loss on a financial asset or financial liability that is measured at fair value shall be recognised in profit or loss.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Exceptions to this requirement: –If the asset is held as part of a hedging relationship –Gains or losses in fair value go to profit or loss occurs if it is an investment in an equity instrument and the entity has elected to present gains and losses on that investment in other comprehensive income in accordance with paragraph –Under paragraph 5.7.5, this is only available in relation to equity investments that are ‘not held for trading’. –Gains or losses on equity investments held for trading must be included in profit or loss. Refer to Worked Example 14.5, p.479—Increase in the fair value of an equity investment held for trading Gains on financial assets measured at fair value (cont.)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Initial recognition of financial liabilities We will now turn our attention to the recognition and measurement of financial liabilities. As we have already indicated, AASB 9 requires financial instruments, and therefore financial liabilities, to be initially recognised in a statement of financial position ‘when the entity becomes a party to the contractual provisions of the instrument’. When a financial liability is initially recognised, it is measured at its fair value in accordance with AASB 9.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Subsequent measurement of financial liabilities Apart from some specific exceptions provided in AASB 9, paragraph 4.2.1: An entity shall classify all financial liabilities as subsequently measured at amortised cost using the effective interest method Refer to Worked Example 14.7, p. 480 for an example of using the effective interest method

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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) The value of a derivative is directly related to another item, for example a share option derives its value from the market value of the underlying shares

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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) 1.Fair value hedges 2.Cash-flow hedges 3.Hedges of net investments in foreign operations Need to differentiate between hedged item and hedging instrument Refer to Worked Example 14.8, p. 482—Hedging arrangement

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 as it arises

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 (and included as part of ‘other comprehensive income’), then transferred to profit or loss to offset gains or losses on hedged item Refer to Worked Example 14.10, p. 485—Cash flow hedge relating to the purchase of inventory

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 14.12, p. 491—Futures trading taking a buy position and Worked Example 14.14, p. 494—Use of currency futures

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Options Put 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 © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Options (cont.) Exercise price Once the exercise price is determined, it remains fixed 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 Options are to be measured at fair value Refer to Worked Example 14.15, p. 497—Valuation of options at net market price

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Swaps Swap agreement –An agreement between borrowers to exchange aspects of their respective loan obligations Commonly used swaps –Interest rate swaps –Foreign currency swaps

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 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 Refer to Worked Example 14.16, p. 498—Foreign currency swap

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Swaps (cont.) Interest rate swaps –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 14.18, p. 503—Interest rate swap

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Compound instruments Contain both a financial liability and an equity component Include convertible notes AASB 132 requirements The Conceptual Framework considers perceived probabilities of conversion: –This is different to the required treatment in AASB 132 Refer to Worked Example 14.19, p. 505—Accounting for compound instruments

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Disclosure requirements Large number of detailed disclosure requirements in AASB 7 Purpose of AASB 7’s disclosure requirements Numerous disclosure requirements in AASB Risks to be disclosed relate to: –credit risk –liquidity risk –market risk

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e Summary The lecture 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

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e AASB 139 provides requirements for recognition and measurement of financial instruments although ultimately it will be replaced entirely by AASB 9 when the IASB’s project on financial instruments is completed Summary (cont.)