1. IAS 32 Financial instruments: Disclosure and Presentation Presented by CPA Peter Njuguna 1

2. Case for financial instruments Dynamics of the international financial markets creates a wide range of financial instruments Financial instruments comprise a mixture of on and off financial statements Financial instruments can significantly contribute to risks that an enterprise faces. 2

3. Objectives Highlights to users of financial statements the range of financial instruments used by an enterprise and how they affect the financial position, performance and cash flows Emphasises on classification of instruments as liabilities or equity. Shift focus from legal form to substance form Example is issue of redeemable preference shares which legally they may be equity but in substance they are debt. This has the impact of increasing the gearing and reduce the net assets 3

4. The standard establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. It 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; and the circumstances in which financial assets and financial liabilities should be offset. 4

5. The standard Complement the principles for recognising and measuring financial assets and financial liabilities in IFRS 9 Financial Instruments, and for disclosing information about them in IFRS 7 Financial Instruments: Disclosures. 5

6. Scope Excluded Share based payments as defined Interests in subsidiaries Interests in associates Interest in joint arrangements Employers rights and obligations under employee benefits plant Rights and obligation arising under insurance contracts 6

7. Initial classification The issuer of a financial instrument should classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument. 7

8. Just a thought Member contribution to a SACCO or welfare schemes Equity or liabilities ??? Refer to IFRIC 2 for clarifications 8

9. Compound financial instrument The issuer of a non-derivative financial instrument should 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 assets or equity instruments. 9

10. Financial instruments  A contract that gives rise to  a financial asset of one entity, and  a financial liability or equity instrument of another entity.  Basic financial instruments are payables, receivables, cash, loans and commitments to make or receive loans. 10

11. Financial assets 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 11

12. Financial assets 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 puttable financial instruments classified as equity instruments. 12

13. Financial liabilities 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; or 13

14. Financial liabilities 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; 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 puttable financial instruments that are classified as equity instruments 14

15. Equity instrument Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Puttable instrument that impose an obligation to deliver a pro-rata of the net assets of the entity only on liquidation When a derivative financial instrument gives one party a choice over how it is settled but all of the settlement alternatives would result in it being an equity instrument. 15

16. Financial Asset  Cash  Contractual right to receive cash or another financial asset or  to exchange financial assets or liabilities under potentially favourable conditions  Equity instrument of another entity Financial liability Equity instrument  Contract evidencing a residual interest in the assets of an entity after deducting all of its liabilities  Contractual obligation to deliver cash or another financial asset or  to ex-change financial asset or liabilities under potentially unfavourable conditions  Certain contracts settled in the entity’s own equity Basic financial instruments 16

17. Exclusion A commodity contract that are expected to be settled by delivery are not classified as financial instruments Except where a commodity future contract has the option to settle in cash or another financial instrument it is classified as financial instrument A contract to deliver a variable number of equity shares, or another financial assets, that depends on the fair value of a certain obligation is also classified as financial instruments 17

18. Example Farmer is contracted by Unga group to cultivate wheat on 200 acre land and deliver the produce on harvest. Unga Ltd will pay Ksh 4,000 for every bag delivered. Explain whether the contract can be classified as financial instrument If the farmer have the option of closing out the contract (pay cash or trade the contract) with the accounting treatment be the same. 18

19. Compound instruments Have the characteristics of both debt and equity A convertible loan gives the holder the option to convert into equity shares at some future date. Require use of split accounting approach The proceeds is analysed between the debt component and the equity component. The debt is measured first and the equity component is the residual The debt is the presented value of mandatory payments discounted at market rate of interest for similar debts without conversion option 19

20. Insight LOGISTICs Ltd has the following entry Issued and fully paid 8% cumulative, convertible, redeemable preference shares (nominal) sh 60 m Explain the accounting classification !!!! 20

21. Compound instrument Vision Ltd issued 100 million 5% convertible bonds at par on 1 st 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 1 st January 2020. the iterest rate of similar bonds without conversion option is 6% Explain how to use split accounting approach 21

22. sol Present value of redemption payment 74,726 Present value of coupon payment 21,062 Value of debt95,788 Value of equity (residual) Proceed on issue 100,000 Less value of debt component 95,788 Equity (share premium) 4,212 22

23. 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 23

24. Finance costs The total payment to be incurred over the lifespan of the debt less the initial carrying value. Allocated to profit or loss over the lifetime of the debt at a constant rate of interest based on the outstanding carrying value per period (effective rate) If a debt is settled before maturity, any profit or loss should be treated in p&l Nb finance cost for qualifying assets capitalised 24

25. Finance cost Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognised as finance 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. 25

26. Initial recognition;  When the entity becomes a party to the contractual provisions of the instrument.  Initial recognition at transaction price  except a financing transaction which includes  Example is sale of goods or services if payment is deferred beyond normal terms.  recognised at discounted amount at a market rate of interest for a similar debt instrument. 26

27. 27 Classification of Financial liabilities Category Definition Financial liabilities at fair value through profit or loss Financial liabilities held for trading Financial liability designated as at fair value through profit or loss on initial recognition Other financial liabilities – at amortised cost All financial liabilities that are not classified at fair value through profit or loss

28. 28 Classification of Financial assets CategoryDefinition Financial assets at fair value through profit or loss  Financial assets held for trading  Derivatives, unless accounted for as hedges  Financial asset designated to this category under the fair value option Loans and receivables Non-derivative financial assets with fixed or determinable payments that are not quoted in an active market Held-to-maturity non- derivative investments Non-derivative financial assets with fixed or determinable payments and fixed maturity that the entity has the positive intent and ability to hold to maturity Available-for-sale financial assets All non-derivative financial assets that are not classified in another category are classified as available-for-sale Any financial asset designated to this category on initial recognition

29. 29 Classification decision Is the asset held for trading or derivatives Does the asset meet the definition of loans and receivables? Will the asset be designated as available-for-sale? Will the asset be designated as at fair value through profit or loss? Does the entity have the positive intent and ability to hold the asset to maturity Financial assets at fair value through profit or loss Loans and receivables Held-to-maturity Available-for-sale Yes No Yes No

30. Derivatives Financial Instruments  Derivatives are contracts with the following characteristics:  Changes in value in response to changes in a specified underlying item  Requires little or no initial net investment  Settled at a future date 30

31. Types of Derivatives  Forwards/ Futures  A (standardized) contract which forms an obligation for one party to buy, and the other to sell, a specific asset, currency or interest rate for a fixed price at a future date.  Options  A contract between two parties, which gives the buying party the right but not the obligation to buy or sell an asset, currency or interest rate for a specified price.  Swaps  An agreement made by two parties to exchange a series of cash flows (for example, fixed interest rate payments for floating-rate payments) in the future. 31

32. Embedded Derivative  A component of a hybrid contract that also includes a non-derivative host  An embedded derivative is the derivative component of a financial instrument that includes both a derivative and a host contract.  An entity is required by IAS 39 to separate an embedded derivative from its host contract but if unable to separately measure the embedded derivative, it should treat the entire combined contract as a financial instrument held for trading. 32

33. Derivative instrument with option When a derivative financial instrument gives one party a choice over how it is settled (eg 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. 33

34. 34 Re-classification out of fair value through P&L Is the instrument derivative ? Would the instrument have qualified as loans and receivable on initial recognition Is there a change of intention or purpose from held for trading was the instrument designated at fair value on initial recognition Re-Classification into fair value through p& L prohibited no No Yes Classify as loans and receivables Yes

35. 35 Re-classifications out of held-to-maturity measurement at fair value Change of intent or ability reclassify ALL instruments Classify as Available For Sale financial assets Sales before maturity reclassify ALL instruments

36. Treasury shares If an entity reacquires its own equity instruments, those instruments (‘treasury shares’) shall be deducted from equity. No gain or loss can 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 should be recognised directly in equity. 36

37. Puttable instruments A contractual obligation for an issuer to repurchase or reedem that instrument for cash or another financial asset on the exercise of the put by the holder. Puttable instrument classified as financial liability unless Holder entitled to pro-rata share of net assets on liquidation It is subordinated to all other class of instrument Have identical features to other subordinated instruments Cashflow due to the instrument only based on profit or loss 37

38. Example A company issues equity share to senior executive of the company on condition that the company will buy back the share on resignation or any exit before retirement. The repurchase price will be 90% of the market price prevailing at that time Explain the accounting treatment of the issue 38

39. Puttable financial instruments Puttable financial instruments classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments. 39

40. Puttable financial instruments As an exception, an instrument that meets the definition of a financial liability is classified as an equity instrument if it has all the features and meets the conditions in paragraphs 16A and 16B or paragraphs 16C and 16D. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. A financial instrument may require the entity to deliver cash or another financial asset, or otherwise to settle it in such a way that it would be a financial liability, in the event of the occurrence or non-occurrence of uncertain future events (or on the outcome of uncertain circumstances) that are beyond the control of both the issuer and the holder of the instrument, such as a change in a stock market index, consumer price index, interest rate or taxation requirements, or the issuer’s future revenues, net income or debt-to-equity ratio. 40

41. Puttable instruments cnd’ The issuer of such an instrument does not have the unconditional right to avoid delivering cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability). Therefore, it is a financial liability of the issuer unless: the part of the contingent settlement provision that could require settlement in cash or another financial asset (or otherwise in such a way that it would be a financial liability) is not genuine; the issuer can be required to settle the obligation in cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability) only in the event of liquidation of the issuer; or The instrument has all the features and meets the conditions in paragraphs 16A and 16B. 41

42. Off setting financial instruments Offset and present on net basis if The entity has a legally enforceable right to set off the recognised amounts The entity intends either to settle on a net basis, or to realise the asset and settle the liabilities simultaneously Example is payable and receivable to the same counter party where the risk associated with the financial asset and liability are identical 42

43. No offsetting if Several financial instrument are used to emulate the features of a single financial instrument Financial assets and liabilities having the same primary risk exposure but involve different counter parties Financial assets pledged as collateral for non-recourse financial liabilities Assets set aside in trust by a debtor for the purpose of discharging an obligation without those assets having been accepted by the creditor in settlement of the obligation Obligation incurred which is recoverable from a third party by virtual of a claim made under an insurance policy 43

44. Interactive session Questions and answers 44