1. 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

2. 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

3. 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 ‘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

4. 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

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) 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

6. 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

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
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

8. 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

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 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. Journal entries for foreign currency swaps
Refer to Worked Examples 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

38. 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

39. 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

40. 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

41. 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

42. Journal entries for compound instruments
Refer to Worked Example (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

43. 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

44. 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

45. 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

46. 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