Ch06 by shuifanglj


									                Prepared by
               Emma Holmes

   Introduction to IAS 32 & 39
IAS 32 sets out the definitions of financial
assets, liabilities and equity instruments and
prescribes detailed disclosures.
IAS 39 includes procedures for the recognition
and measurement of financial instruments.
One of the most controversial development
areas in recent times, especially hedge

     What is a financial instrument?
Financial instrument

Financial assets > defined from holder’s perspective
Financial liabilities and equity >defined from issuer’s
Equity instrument
Defined as any contract that results in the entity
retaining a residual interest in assets after deducting
all liabilities (example: ordinary share)

     What is a financial instrument?

Primary instruments:
   eg. cash, receivables, investments, payables
   few issues with accounting for these
Secondary (derivative) instruments:

   eg. financial options, forward exchange contracts
   more difficult to account for

   What is a financial instrument?

A two-sided contract. All financial instruments will
give rise to a financial asset of one party, with a
corresponding financial liability or equity instrument
of another party.

Definition requires a legal/contractual right. Non
contractual liabilities are not financial instruments.

Derivatives transfer financial risks of the underlying
primary financial instrument
One party acquires a right to exchange a financial asset or
liability with another party under potentially favourable
conditions. The other party takes on the right to exchange
under potentially unfavourable conditions.
Parties to derivatives are ‘taking bets’ on what will
happen to it in the future
More on derivatives later in this lecture

      Financial liabilities vs equity
  Debt/equity distinctions are important – affects
  gearing and solvency ratios, debt covenants,
  treatment of payments as either interest or
  dividends, and capital adequacy requirements
  A ‘substance over form’ test in IAS 32 aims to
  limit attraction to misclassify many as equity
  instruments. There are two parts to the test –
  parts A & B.

     Financial liabilities vs equity
     instruments – substance over form test
  Part A > An equity instrument must include no
  contractual obligation to:
     Deliver financial assets to another entity
     Exchange assets/liabilities unfavourable to the issuer

  Part B > Equity instruments settle in its own equity

  Contingent settlement provisions and settlement options
  are common

      Financial liabilities vs equity
      instruments – contractual obligations
  A issues 1 million preference shares.
  Shareholders are entitled to a 5% p.a non-cumulative
  Preference share are non-redeemable.

How should these preference shares be classified?

     Financial liabilities vs equity
     instruments – contractual obligations
  A issues 1 million preference shares.
  Shareholders are entitled to a 5% p.a cumulative
  Preference share are redeemable for cash at the option of
  the holder.

How should these preference shares be classified?

      Financial liabilities vs equity
      instruments – settlement in equity
  A has an obligation to deliver $100,000 worth of
  shares to B in 3 months time.

How should the obligation be classified?

      Financial liabilities vs equity
      instruments – settlement in equity
  A issues an option to B entitling B to buy $100,000
  shares at $1 each in 3 months time.

How should the options be classified?

     Compound financial instruments

  Compound financial instruments comprise a combination
  of liability and equity eg – convertible note.
  A issues 2,000, $1,000, 3-year convertible notes
  The notes pay interest at the rate of 6% annually in
  The prevailing market interest rate for notes without
  conversion options are 9%.
  The note holder is entitled to convert the note into 250
  shares at any time until maturity.

How should the notes be classified?

      Compound financial instruments

    IAS 32 requires the liability component to be calculated
    first, the equity component being residual.
    The issuer calculates the PV of the cash flows to
    determine the value of the option (based on the market
    rate of 9%)

      Presentation issues
  Interest, dividends, gains and losses in income statements must
  match their balance sheet classification
     Liability >
     Equity >
  Assets/liabilities can often be offset

  The purpose of disclosures prescribed by IAS 32 is to:
    aid understanding of entity’s financial position/
    performance/cash flows, and
    assess amounts, timing and certainty of future cash flows


     An instrument whose value is derived from underlying item:
     share price, interest rate, etc.
     3 main characteristics
       1.     Value changes in response to the change in a specified variable –
              eg. Interest rate, foreign exchange rate.
       2.     Requires no/minimal net investment
       3.     Settled at some time in the future
     Include futures, forward, swap and option contracts
     Most derivatives are settled on a net basis.
     May be standalone or embedded in a compound (‘hybrid’)

      Categories of financial instruments

  IAS 39 recognises 4 categories of financial
  instruments as follows:
       1. A    financial asset or liability at fair value
            through profit or loss
       2. Held-to-maturity          investments
       3. Loans      & receivables
                          financial assets
       4. Available-for-sale

  Each of these are considered on the following slides.

      Categories of financial instruments

Category        Characteristics                     Examples

Financial      Meets one of two conditions:         Share portfolio held for
asset or        Held for trading; or                short term gains, forward
liability at    Designated upon acquisition as      exchange contract, interest
fair value      being held at FV with changes       rate swap, call option (all
through         in FV being recorded through        derivatives other than
profit or loss  P&L                                 hedges)

Held-to-          Non derivative financial assets   Commercial bill
maturity          with fixed or determinable        investments, govt. bonds,
investments       payments and fixed maturity       fixed term debentures,
                  The entity has the positive       convertible notes (which
                  intention and ability to hold     convert at a fixed date in the
                  these assets until maturity       future)

       Categories of financial instruments

Category      Characteristics                      Examples

Loans &       Non-derivative financial assets      Accounts receivable,
receivables   with fixed or determinable           loans to other entities
              payments that are not quoted in an
              active market
Available for Non-derivative financial assets that Ordinary share
sale financial are designed as available for sale  investments, other
assets         and do not fall into any of the     convertible notes
               above categories

        Recognition criteria

   A financial instrument is recognised when the entity
   becomes a party to the contractual provisions of the

       Measurement criteria

   IAS 39 measurement rules address:
       Initial measurement
       Subsequent measurement
       Fair value measurement considerations
       Gain and losses
   Refer table 5.8 of the text (pg 158) for a summary of the
   measurement rules for the different categories of financial

     Initial measurement
  Initial recognition =
  Fair value >
  Where the consideration is for something other than the
  financial instrument the valuation techniques may be required
  to estimate the fair value.
  Eg- interest free loan to employees > part of the consideration
  is for “loyalty”. Fair value of the loan must be calculated and
  any difference accounted for as an expense.
  Transaction costs include fees and commissions, taxes and

      Subsequent measurement
Financial assets:
  Derivatives (other than hedges) and for-sale assets –

  Loans, receivables and investments held
  to maturity –
Financial liabilities:
  Derivatives (other than hedges) and for-sale assets –

  All other financial liabilities –

     Subsequent measurement – amortised
  Amortised cost (AC) is calculated using the effective
  interest method.
  The effective interest method is a method of
  calculating amortised cost and of allocating interest
  income or expense over the relevant period.

       Subsequent measurement – amortised
       cost - example
    A purchases a held-to-maturity debt instrument with a
    5 year term for its fair value of $1,000.
    The principal payable on redemption is $1,250.
    The fixed interest rate is 4.7% pa. and the effective
    interest rate is 10% pa.

  Determine the cash flows and interest income for
  each period.

       Subsequent measurement – amortised
       cost - example
Year       AC at     Interest Cash flows AC at end of
        beginning income (B)     (C)        year
        of year (A) (A x 10%)             (A+B-C)

       Fair value measurement
‘Fair value hierarchy’ determines order
    of sources of fair value as:
   1. Quoted price (if active market) – normally
      the current bid or asking price
   2. Valuation technique (if no active market) –
      eg via discounted cash flow analysis
   3. Equity instruments (if no active market) –
      must be measured at cost

       Impairment and uncollectability

Category               Impairment losses recognised as follows…
At FV through P&L      N/A – impairment rules do not apply

Held-to maturity       Difference between the CA and the PV of
investments            expected future cash flows discounted at the
                       assets original effective interest rate (refer
                       example 5.3 in text)
Loans & receivables    As above
Available-for-sale     Cumulative losses recognised directly in equity
financial assets       must be removed and recognised in P&L (refer
                       example 5.4 in text)

        Hedge accounting - introduction

   Hedge arrangements are entered into to protect an
   entity from risk – eg currency or interest rate risk.
   Hedge accounting generally results in a closer
   matching of balance sheet/profit & loss effects
   Protects the income statement from volatility caused
   by fair value changes over time

       Hedge accounting - definitions
Hedging instrument
  A hedging instrument is a financial asset or financial liability whose
  fair value or cash flows are expected to offset changes in the fair
  value or cash flows of a designated hedge item.
  8 essential criteria for an instrument to be classified as a hedging
Hedged item
  A hedged item is an asset, liability or anticipated transaction that:
      Exposes the entity to risk of changes in fair value or future cash
      flows; and
      Is designated as being hedged.

     Hedge accounting - conditions
5 conditions must be met in order for hedge accounting to be
   Must be formal designation and documentation of the hedge at
   The hedge must be expected to be highly effective (80% -

  For cash flow hedges the transactions must be highly probable
  The effectiveness of the hedge must be able to be reliably
  The hedge must be assessed on an ongoing basis for

      Hedge accounting – types of hedges

  Fair value hedge

  Cash flow hedge

  Hedge of a net investment in a foreign operation

      Cash flow hedge - example

         Hedge accounting – fair value
     On 1 July 2005 Z invested $250,000 in an available-for-sale
     equity instrument.
     On 1 September 2005 Z entered into a futures contract to
     hedge the FV of the investment.
     At 30 June 2006 the FV of the investment was $230,000 and
     the FV of the futures contract was $18,000.
  (a) Prepare the accounting entries for the 30 June 2006 year.
  (b) Determine the effectiveness of the hedge.

         Hedge accounting – fair value
  1 July 2005

    Initial recognition of the investment

  1 September 2005

        Hedge accounting – fair value
30 June 2005

  Remeasurment of investment and futures contract

Effectiveness of the hedge

      Hedge accounting – cash flow
   On 30 June 2005 A enters into a forward exchange contract to received
   FC100,000 and deliver LC109,600 on 30 June 2006.
   The company has a firm commitment to purchase a specified quantity of paper
   on 31 March 2006 for FC100,000. Settlement is due on 30 June 2006.
   A has elected to account for the hedge as a cash flow hedge.
   Exchange rates and information about the forward contract at relevant dates are:

    Date                Spot rate          Forward rate to 30        FV of forward
                                              June 2006                contract
30 June 2005              1.072                   1.096                     -
31 March 2006             1.074                   1.076                  (1,971)
30 June 2006              1.072                      -                   (2,400)

           Hedge accounting – cash flow
Prepare the accounting entries for the 30 June 2006 year.
30 June 2005

31 March 2006

Recording the change in the FV of the forward contract

        Hedge accounting – cash flow
31 March 2006

Recording the purchase of the paper at the spot rate

Removing the cumulative loss recognised in equity

      Hedge accounting – cash flow
30 June 2006

Recording settlement of the payable at the spot rate

Recording loss on forward contract 1/4/06 – 30/6/06

       Hedge accounting – cash flow
30 June 2006 (cont).

Recording net settlement of forward contract

  Total cash paid: $107,200 + $2,400 = $109,600
  > agrees to LC amount locked in on 30 June 2005.
  Net FX loss = $229 > represents ineffective portion of hedge.


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