Vous êtes sur la page 1sur 65

FinancialInstruments

FundamentalsofFinancialInstrument Derecognition HedgeAccounting


Sajid Shafiq,ACA

Fundamentals
Financialassets, , liabilitiesand equity equ tyinstruments st u e ts Classificationof FinancialAssets

Classificationof FinancialLiabilities
FinancialInstruments

Regular g Way y Contracts


2

Financialassets,liabilitiesandequity instruments
Thedefinitionofthefinancialinstruments. The h li liability/equity bili / i di distinction i i Compoundinstruments. IncomeStatementClassification Transactioninownequity

FinancialInstruments

FinancialInstrument
isanycontractthatgivesrisetoboth: Afinancialassetofoneentity
FinancialAsset a) ) Cash; h b) anequityinstrumentofanotherentity; c) acontractualright: i. toreceivecashoranotherfinancialasset f from another h entity;or ii. toexchange financialassetsorfinancial liabilitieswithanotherentityunder conditionsthatarepotentiallyfavourable to the h entity; i or d) acontractthatwillormaybesettledinthe entitysownequityinstrumentsandis: i. anonderivativeforwhichtheentityisor maybe b obliged bli dtoreceive i avariable i bl number b oftheentitysownequityinstruments;or ii. aderivativethatwillormaybesettledother thanbytheexchangeofafixedamountof cash horanother h financial fi i lassetfor f afixed fi d numberoftheentitysownequity instruments.

Eitherafinancialliabilityoranequity instrumentofanotherentity.
FinancialLiability a) ) acontractual lobligation bl : i. todelivercashoranotherfinancialasset toanotherentity;or ii. toexchangefinancialassetsorfinancial l bl liabilities with hanother h entityunder d conditionsthatarepotentially unfavourable totheentity;or b) acontractthatwillormaybesettledinthe entitys i ownequity i instruments i and di is: i. anonderivativeforwhichtheentityisor maybeobligedtodeliveravariable numberoftheentitysownequity i instruments; or ii. aderivativethatwillormaybesettled otherthanbytheexchangeofafixed amountofcashoranotherfinancialasset f afixed for fi dnumber b of fthe h entitys i own equityinstruments.
4

FinancialInstruments

Equityinstruments Anequityinstrumentisacontractthatevidencesaresidualinterestintheassets ofanentityafterdeductingallofitsliabilitiesandrepresentsafinancialassetof theholderandequityoftheissuer.

Classify?? Debtors BankLoans InvestmentinTFCs TFCsissued Inventory Prepayment Advancesfromcustomers Sharesissued Provision fortaxes Dividends payable
FinancialInstruments 5

Liabilityversusequitydistinction
Somefinancialinstrumentshavethe legalformofequitybutare,in substance,liabilities.Forexamplean i issuer has h acontractual t t lobligation bli ti t to eitherdelivercashoranother financialasset. UnderIFRStheissuershouldclassify theinstrument,oritscomponent parts,asafinancialliabilityoras equityinaccordancewiththe bt substance of fth thecontractual t t l arrangementoninitialrecognition, andthedefinitionsofafinancial liability yandaequity q yinstrument.The classificationmadeatthedateof issue Normallyweevaluatewithreferenceto: Redemption.existenceofa contractualobligation Return. Otherconditions NOTE: arestrictionontheliabilityoftheissuerto satisfyanobligation,suchaslackofaccess toforeigncurrencyforforeigncurrency borrowingsortheneedtoobtainapproval forpaymentfromaregulatoryauthority, doesnotnegatetheexistenceofthe liability.

ContingentSettlement Provisions:Itisafinancialliabilityoftheissuerunlesschancesof settlementincashisremote(ingenuine conditionsorliquidation)


FinancialInstruments 6

CompoundInstruments
Somefinancialinstruments,calledcompoundinstruments, havebothaliabilityandanequityelement. Inthiscase case,IAS32requiresthecomponentpartstobe separatedfromeachother,witheachpartaccountedfor andpresentedseparatelyaccordingtoitssubstance. To T illustrate, ill t t aconvertible tibl bond b dcontains t i two t components. t
Oneisafinancialliability,theissuerscontractualobligationto paycash(principalandinterestonthebond),and Theotherisanequityinstrument, instrument acalloptionwrittentothe holdertoconvertthedebtsecurityintocommonshares.

Theseparationofcomponentsismadeatthetimethe instrumentisissuedandisnotsubsequentlyrevisedasa resultofachangeininterestrates,shareprice,orother eventthatchangesthelikelihoodthattheconversionoption willbeexercised.


FinancialInstruments 7

CompoundInstruments
Illustration DTplcissues 2,000convertiblebondsatthestartof2008 Thebondshaveathreeyearterm, term Issuedatparwithafacevalueof1,000perbond. Interestispayableannuallyinarrearsat6%. Eachbondisconvertibleattheholdersdiscretionatany ytimeup ptomaturity yinto250 ordinarycommonsharesofDTplc. Thepresentvalueofbondcashflowsatamarketrate(say10%) ofinterestforasimilar financialinstrumentwithouttheequityconversionoption 1,801,052 1 801 052.Thisistheliability component. Thedifferencebetweentheissueproceeds,2,000,000,andthefairvalueoftheliability componentisassignedtotheequitycomponent198,948. Dr.Bank Cr FinancialLiability Cr. Cr.Equity 2,000,000 1,801,052 1 801 052 198,948
FinancialInstruments 8

IssueCost
Issue(transaction)costrelatingtoissuance ofequityisdeductedfromequity(32.35) Transactioncostrelatingtoissuanceof liabilityshallbedeductedfrom liability(IFRS9,5.1.1) Transactioncostoncompoundfinancial instrumentwillbeallocatedonprorata basisofinitiallyrecognizedamounts.

IncomeStatementClassification
Interest Interest,dividends, dividends lossesandgains relatingtoafinancialinstrumentora componentthatisafinancialliabilityshall berecognised asincomeorexpensein profitorloss. p Distributionstoholdersofanequity instrumentshallbedebitedbytheentity directlytoequity,netofanyrelated incometaxbenefit.

TreasuryShares
Ifanentityreacquiresitsownequityinstruments,thoseinstruments (treasuryshares)shallbedeductedfromequity. Nogainorlossshallberecognised inprofitorlossonthepurchase,sale, issueorcancellationofanentitys entity sownequityinstruments instruments. Suchtreasurysharesmaybeacquiredandheldbytheentityorbyother membersoftheconsolidatedgroup. Considerationpaidorreceivedshallberecognised directlyinequity.

FinancialInstruments

Alittletesting
LSissuesa$100,000notepayable.Theterms oftheinstrumentaresuchthatitwillrepay theloannoteusingitscommonsharestothe valueof$100,000theloannote Theloannoteisrecognizedas
a. FinancialLiability y b. Equity c. CompoundFinancialInstrument
FinancialInstruments 10

AccountingissuesofFAandFL
Measurement:
Initialandsubsequentmeasurementisbasedon theclassificationofFAandFL

Recognition:
AdditionalguidelinesforRegularWayContracts

De recognition:
DetailedguidelinesforderecognitionofFAandFL

FinancialInstruments

11

ClassificationofFinancialAssets
UnderIAS39 FVTPL Heldfortrading, derivatives,(otherthanthosequalify forhedgeaccounting) FVOption(irrevocable) Heldtomaturity Intentionandabilitytohold,loan notes TFCs notes, LoansReceivables Debtors,loanstoemployeesetc. AFS Residual category Irrevocableoption p FVTPL Same UnderIFRS9

Atamortized cost Businessmodel& ContractualCashflows (the previousHTMandLRcategory willnowfallhere) FV OCI Underirrevocableoptiononlyfor investmentinequitynotheldfor trading d (IFRS ( 9,5.7.5) )

FinancialInstruments

12

ClassificationofFinancialLiabilities
UnderIAS39&IFRS9 Atamortized ti dcost t(default (d f ltcategory) t )except t FinancialliabilitiesatFVTPL(HFT,derivatives) Financialliabilitiesthatarisewhenatransferofafinancialasset doesnotqualifyforderecognition Financialguaranteecontracts Commitmentstoprovidealoanatabelowmarketinterestrate.

FinancialInstruments

13

Measurement
Financial instrument
Financial assets and liabilities at FVTPL

Measurement at recognition
Fair value

Subsequent measurement
Fair Value

Recognition in statement of comprehensive income


Interest/dividends taken through PL Fair value gains and losses in PL

At Amortized cost: (HTM and LR) FV-OCI (AFS)

Fair Value p plus transaction cost Fair Value plus transaction cost

Amortised cost using g the effective interest rate Fair value

Interest calculated using g the effective rate in PL Interest/dividends taken through PL FV Gains and losses as other comprehensive income. When an asset is sold ( or impaired or derecognized) the cumulative gain or loss is recycled to PL

Other financial liabilities

Fair Value less transaction cost

Amortised cost using the effective interest rate

Interest calculated using the effective rate PL

FinancialInstruments

14

FVTPLandFVOCI(AFS) ComparisonIllustration ll
Jonesbuysaninvestmentfor$40million.The transactioncostsare$1million..Attheyearend thevalueoftheassethasrisento$60million. Shortlyaftertheyearendtheassetissoldfor $70million. Howshouldthisbeaccountedforifthe investmentisclassifiedas:
Fairvaluethroughprofitandloss FVOCI(AFS)
FinancialInstruments 15

FVTPLandFVOCI ComparisonIllustration ll
FVTPL Initial recognition Dr.Investment40m Dr.Expense1m Cr.Bank41m AFS Dr.Investment41m Cr.Bank41m

Atyear end

Dr.Investment20m Cr Profit&Loss20m Cr.

Dr.Investment19m Cr OtherComp. Cr. Comp Incm 19m

OnDisposal

Dr.Bank70m Cr. Investment60m Cr.Profit&Loss10m

Dr.Bank70m Dr.OtherComp.Incm 19m Cr. Investment60m Cr.Profit&Loss29m

FinancialInstruments

16

Subsequentmeasurement Amortised d cost


Financialassetsandfinancialliabilitiesaremeasuredafterinitialrecognitionin accordancewiththemeasurementbasisthatisconsistentwiththeclassification categoryoninitialrecognition(exceptinthecaseofspecificrequirementsfor hedgeaccounting) Amortised cost FinancialassetsthatareclassifiedasHTMassets assets,orasloansandreceivables receivables,or financialliabilitiesthatarenotdesignatedatFVTPLaremeasuredatamortised cost.Amortised costofafinancialassetorfinancialliabilityis:
Initialamountrecognized(costincludingtransactioncosts) Minusprincipalrepaymentsmade Pluscumulativeamortizationofanydifferencebetweenthatinitialamountandthematurity amount(accruedusingtheeffectiveinterestmethod) Minuswritedownforimpairmentoruncollectability (directlyorthroughtheuseofan allowanceaccount)

Effective Eff ti interest i t trate t method th d Theeffectiveinterestrateistheinternalrateofreturn(IRR)orthelevelyieldto maturity,i.e.theratethatexactlydiscountstheestimatedfuturecashflowsor receiptsthroughtheexpectedlifeoftheinstrument,orwhereappropriate,a shorterperiod, period tothenetcarryingamountatinitialrecognition. recognition
FinancialInstruments 17

EffectiveInterestRateandAmortized CostIllustration ll
On1January20X1Jamesissuedadeep discountbondwitha$50,000nominal value.Thediscountwas16%of nominalvalue,andthecostofissue was$2,000.Interestof5%ofnominal valueispayableannuallyinarrears. Thebondmustberedeemedon1 January20X6(after5years)ata premiumof$4,611. Theeffectiverateofinterestis12%p.a. Letsseehowwillthisbereportedin thefinancialstatementsofJamesover theperiodtoredemption?
Firstly, we must establish at what amount the bond will ill be initiall initially recognised in the statement of financial position. Net precedes $ Face value 50,000 Less: 16% discount (8 000) (8,000) Less: Issue costs (2,000) Initial recognition of liability (a) Repayments Capital Premium on redemption Principal to be redeemed Interest paid: $50,000 x 5% x 5 years (b) Total Finance Cost (b-a)
FinancialInstruments

40,000

50,000 4,611 54 611 54,611 12,500 67,111 27,111


18

EffectiveInterestRateandAmortized CostIllustration ll
Secondly, we set up a table (similar to that used for compound instruments) to work out the balance of the loan at the end of each period. (SCI-IS) (SCF) (SFP) Year Op Bal Op. Effective Intt(12%) Payments(5%) Cl Bal (amort cost) Cl. $ $ $ $ 1 2 3 4 5 40,000 42 300 42,300 44,876 47,761 50,992 4,800 5 076 5,076 5,385 5,731 6,119 _______ 27,111 _______ (2,500) (2 500) (2,500) (2,500) (2,500) (2,500) _______ (12,500) _______ 42,300 44 876 44,876 47,761 50,992 54,611

FinancialInstruments

19

RecognitionofFAandFL
Anentityshallrecognise afinancialassetorafinancialliabilityinitsstatementoffinancial positionwhen,andonlywhen,theentitybecomespartytothecontractualprovisionsofthe instrument Whenanentityfirstrecognises afinancialasset/financialliability,itshallclassifyitasdiscussed earlierandmeasureitaccordingly.

RegularWayCOntracts Contractstobuyorsellfinancialassets(forexample,contractstobuy securitiesonanexchange)willhavestandarddeliverytermsprescribedbythe exchange.Forexample,transactionsofsecuritiesmayberequiredbythe exchangetobesettledthreedaysafterthetradedate atradetakingplace todaymustbepaidfor(ifpurchased)ordelivered(ifsold)threebusinesses daysfromthetradedate.Forexampleatradeexecutedon11Maysettleson 14May.Thiskindofsettlementisknownasregularwaysettlement. Thefixedpricecommitmentbetweentradedateandsettlementdateisa forwardcontractthatmeetsthedefinitionofaderivative.However,because oftheshortdurationofthecommitment,suchacontractisnotrecognizedas aderivativefinancialinstrumentunderIFRS9. 9
FinancialInstruments 20

RegularWayContracts
Thestandardpermitseithertradedateaccountingor settlementdateaccountingforregularwaypurchases orsalesofafinancialasset, Tradedateaccounting accountingandsettlement settlementdate Trade accountingrefertomethodsofrecognizinganasset acquired(andanyassociatedliabilityincurred)and derecognizinganassetsold(andanyassociated receivablerecognized). Themethodusedmustbeappliedconsistentlyforall purchasesandsalesoffinancialassetsthatbelongto thesamecategoryoffinancialassets,asdefinedinIFRS 9.Thechoiceofmethodisanaccountingpolicy.
FinancialInstruments 21

TradeDateorSettlementDate Example

FinancialInstruments

22

TradeDateAccounting
Classification of the Amortised cost asset investments (HTM, LR) FV-OCI (AFS) 29 December 20x4 Dr asset 1,000 Dr asset 1,000 Cr liability 1,000 Cr liability 1,000
Description To recognise asset and to record To recognise asset and to payable record payable

FVTPL Dr asset 1,000 Cr liability 1,000


To recognise asset and to record payable

31 D December b 20X4 --Description

Dr asset 2 Cr equity 2
with the increase in FV to date

Dr asset 2 Cr profit or loss 2


with the increase in FV to date

4 January 20X5 --Description

Dr asset 1 Cr equity 1
with ith th the i increase i in FV t to d date t

Dr asset 1 Cr profit or loss 1


with the increase in FV to date

Dr liability 1,000 Cr cash 1,000


Description

Dr liability 1,000 Cr cash 1,000

Dr liability 1,000 Cr Cash 1,000

with the amount contracted with t the t e amount a ou t contracted co t acted to pay with t the t e amount a ou t contracted co t acted to to pay for t f the th asset t in i FV to t for the asset in FV to date pay for the asset in FV to date date FinancialInstruments 23

SettlementDateAccounting
Classification of the Amortised cost asset investments (HTM, LR) FV-OCI (AFS) 29 December 2004 ----31 December 2004 -Dr receivable 2 -Cr equity 2
Description

FVTPL --Dr receivable 2 Cr profit or loss 2

with the increase in FV to date with the increase in FV to date

4 January 2005 --Dr asset 1,000 Cr cash 1,000 -Description

Dr receivable D i bl 1 Cr equity 1 Dr asset 1,003 Cr cash 1,000 Cr receivable 3

Dr receivable D i bl 1 Cr profit or loss 1 Dr asset 1,003 Cr Cash 1,000 Cr receivable 3

with the amount contracted to with the amount contracted to with the amount contracted to pay for the asset i.e. FV of trade pay for the asset and changes pay for the asset and changes date in its FV since trade date in its FV since trade date

FinancialInstruments

24

DerecognitionofFinancialAsset
Afinancialassetshouldbederecognizedifoneofthefollowingcriteria occur: thecontractualrightstothecashflowsofthefinancialassethave expired,e.g.whenanoptionheldbytheentityhasexpired worthless thefinancialassethasbeensoldandthetransferqualifiesfor derecognition becausesubstantiallyalltherisksandrewardsof ownershiphavebeentransferredfromthesellertothebuyer. Theanalysisofwheretherisksandrewardsofownershiplieafter thetransactioniscritical.Forexampleifanentitysellsan investmentinsharesandentersintoatotalreturnswapwiththe buyer thebuyerwillreturnanyincreasesinvaluetotheentityor buyer, theentitywillpaythebuyerforanydecreaseinvalue.Inthiscase theentityhasretainedsubstantiallyalloftherisksandrewardsof theinvestment,whichthereforeshouldnotbederecognized.
FinancialInstruments 25

DerecognitionofFinancialAsset Illustration ll
BellbuysaninvestmentfortradingpurposesfromBook.Itcost$10 million illi at t1J January20X7. 20X7 At31December D b 20X7, 20X7 the th investment i t thad h da fairvalueof$30million.On1June20X8Bellsoldtheinvestmentto Candleforitsmarketvalueof$100million. Nowletssee. 1. 1 2. 3. Howshouldthisbeaccountedfor? WouldtheanswerhavebeendifferentifBellspurchasecontract hadcontainedaputoptiongivingBellthepowertosellthe investmentbacktoBookatmarketvalueon31December20X8? WouldtheanswerhavebeendifferentifBellssalecontracthad providedBellwithacalloptionandCandlewithaputoption overtheinvestment,eachatapriceof$105millionoverthe next12months?
FinancialInstruments 26

DerecognitionofFinancialAsset Illustration ll
(1)TheinvestmentboughtbyBellisfortradingpurposes,soitwillbeclassifiedasatfairvalue through h hprofit fi and dl loss. Onpurchase,theassetisrecordedattheconsiderationpaid: $m DrAsset 10 CrCash 10 At31December20X7theassetisremeasuredat$30million,withtheupliftbeingrecognised in profit fitorl loss: DrAsset 20 CrProfit 20 Ondisposal,theassetisderecognised andagainreported DrCash 100 CrAsset(10+20) 30 CrProfit 70

FinancialInstruments

27

DerecognitionofFinancialAsset Illustration ll
(2)TheputoptiongivesBellthepowertoselltheassetbacktoBookon31 December20X8 20X8.Butthisoptionhasnotcomplicatedthings things,becauseBellhas notexerciseditbuthassoldtheunderlyingassettoCandle. Alltheentriesarethesameasabove. (3)TheeffectofBellscalloptionisthatifthepriceoftheunderlyingasset goesup,to,say,$160million,Bellwillexerciseitscalloptionat$105million. TheeffectofCandlesputoptionisthatifthepricefalls,to,say,$60million, CandlewillputtheunderlyingassetbacktoBellat$105million million. ThesubstanceofBellssalecontractisthatitisaloanof$100millionwhichis repayablewithinterestof$5millionafteroneyear.Therisksandrewardsof ownershipremainwithBell,sotheassetcannotbederecognised. Thethirdentryisdifferent.($m) DrCash 100 CrLiability 100
FinancialInstruments 28

A
Financial Inst truments 29

DerecognitionofFinancialLiabilities When h toDerecognize


Generallyafinancialliabilityisderecognizedonlywhenitisrelinquished,i.e. whentheobligationis: is Discharged Anobligationisdischargedifanentitydelivers:
Cash Otherfinancialassets Othergoods

Whichthecounterpartyacceptsassuitablecompensation. Cancelled Cancellationofanobligationonlyoccursthroughaprocessoflawwherebyan entityislegallyreleasedfromitsprimaryobligationtopaythecreditor. creditor Expired Anobligationexpiresduetothepassageoftime.


FinancialInstruments 30

AccountingofFLDerecognition
Accountingfortheextinguishmentofa liabilityisrelativelysimple. Whentheliabilityisextinguished,recognizein profitandlossthedifferencebetweenits carryingamountandtheconsiderationpaid includingany:
Noncashassetstransferred and Newliabilitiesassumed.
FinancialInstruments 31

ExchangeorRenegotiation
Oftenentitieschoosetomodifyorrenegotiatetheirdebt: IAS39draws d adistinction di i i b betweeneventsthat h areconsidered id dtobe b either i h of f thefollowing: Modificationoftheexistingliability Ifaliability yismodifiedorexchanged, g ,buttheoldandnewtermsarenot substantiallydifferent,thenthefeesandcostattributabletotherenegotiation arerolledintothecarryingvalueoftheexistingliabilityandamortizeduntil maturity. Extinguishmentoftheexistingliabilityandassumptionofnewone Ifaliabilityismodifiedorexchanged,andtheoldandnewtermsare substantiallydifferent,thenthemodificationortheexchangeisaccountedfor asanextinguishmentoftheoriginalliability liability. Thenewliabilityisinitiallyrecognizedatitsfairvalue,whichresultsinthe recognitionofgainorlossifthecarryingamountoftheoriginalliabilitydiffers fromthefairvalueofthenewliability.Anycostsorfeesincurredare recognizedinprofitorlossaspartoftheextinguishment. extinguishment
FinancialInstruments 32

Reneg R gotiationIllustration

PSCwasfacingdifficultiesduringtheyearendedDecember31,2008.InOctober2008,PSC commencednegotiationswiththelendersforrestructuringofloans. Summarypriortorestructuringon31Dec08:

Lenders
SBD Loanamount(US$) RemainingNo.of p.a.equalinstallmentsincluding dueonDecember31,2008 Interestrate 350,000 5 2.50% JICA 500,000 4 3.00% AFI 270,000 3 2.00%

LoansareappearingattheexchangerateofUS$1=Rs.65.Theexchangerateasattheendof theyearisUS$1=Rs.80. AgreementswithSBDandAFIwerefinalizedandsignedbeforeyearend,however,the agreementwithJICAwasfinalizedinJanuary2009.Reschedulingdetailsare:

SBD
Revisedvalueofloanamount(US$) $ RevisedPVasperoriginaleffective interestrate(US$) Revised R i dPVaspermarket k tinterest i t t rateforsimilarinstruments(fairvalue)(US$) Firstinstallmentdueon 370,000 390,000 400 000 400,000 31Dec10

JICA
525,000 535,000 510 000 510,000 31Dec11

AFI
280,000 250,000 220 000 220,000 31Dec12

FinancialIn nstruments

33

FinancialInstruments

34

HedgeAccounting

IdentifyingDerivatives
Definition Aderivativeisafinancialinstrumentorothercontract withinthescopeofIAS39.
Whosevaluechanges g inresponse p tothechange g inan underlyingvariableand Thatrequiresnoinitialnetinvestmentoraninitialnet investmentthatissmallerthanwouldberequiredforother typesofcontractsthatwouldbeexpectedtohaveasimilar responsetochangesinmarketfactorsAND Thatissettledatafuturedatederivativesareheldfortrading financialinstrumentandaremeasuredatfairvaluewithfair valuegainsandlossestakentotheincomestatement immediatelyunlesstheyaredesignatedhedginginstrumentsin ahedgingrelationship.
FinancialInstruments 36

Underlyingvariable
Anunderlyingvariableisaspecificprice,index,orothervariableusedasae referencefordeterminingthevalueofaderivativecontract.Changesinthe underlyingvariableresultinchangesinthefairvalueofaderivativecontract. Herearethreeexamplesofunderlyingvariables:
Price
Ifthepriceofcornchanges, thefairvalueofthefuture salesvalueofafarmerscorn changes.Thereforethefair valueofafuturescontractto sellcorninthefutureata pricespecifiedtodaywill changewhenevertheprice ofcornchanges. Theunderlyingvariablehere isthepriceofcorn. corn

Interestrate
Ifmarketinterestratesfall thefairvalueofafixedrate receivablewillincrease. Similarlythefairvalueofan interestrateswapcontractto swapavariablerateof interestforafixedrateof interestwillchangeas interestrateschange. Theunderlyingvariablein theseexamplesisthe interestrate.

Exchangerate
Ifa functionalentityhas$ borrowingsandthe$ increasesinvalueagainstthe thenthevalueofthe entitysborrowingsandthe equivalentcostofthe interestpayableonits borrowingswillincrease. Similarlythefairvalueofa forwardcontracttoexchange $for atap pricefixedtoday y wouldchangewithchanges inthe$/ exchangerate. Theunderlyingvariablein bothcasesisthe/$ exchange h rate. t
37

FinancialInstruments

DerivativesandthescopeofIAS39
Contracts Manyexecutorcontractstobuyorsellnonfinancialitemsmeetthe definitionofthederivative,forexample,acontracttobuyorsell computersforafixedpriceatafuturedate date. Generally,contractsthatrequireapaymentbasedonphysical variablesarescopedOUTofIAS39 Howeveracontracttobuyorsellanonfinancialitemsiswithinthe scopeofIAS39ifitcanbesettlednetcashoranotherfinancial instrument,orbyexchangingfinancialinstrument,andisnot enteredintoandcontinuestobeforthepurposeofthereceiptor deliveryofthenonfinancialiteminaccordancewiththeentitys expectedpurchase,salesorusagerequirements.
FinancialInstruments 38

Typesofrisk
Findaboutsomecommontypesofrisk Afarmergrowscorn.Thefarmerisvulnerabletochangesinthepriceofcornifcornprices fallasthefarmerscorngrowsthefarmerisexposedtoafallinthepotentialsalesvalueof thecornharvest. Acommercialbankisexposedtochangesininterestrates(thepriceofmoney).Thebankhas investmentsindebtsecuritieswithfixedratesofreturn( (fixedrateassets). ) Thesamebank alsopaysvariableratesofinterestonthedepositsofitscustomers(ithasvariablerate liabilities). Ifinterestratesincreasesthecurrentmarketvalueofthebank banks sfixedrateassetswillfall fall. Higherreturnscouldpotentiallybemadeelsewhereonassetscarryingahighervariablerate ofinterest.Atthetimethebanksvariableinterestrateliabilities theinterestpaymentsit makestoitscustomersontheirdepositswillincrease. AcardealerbasedintheUnitedStatesimportscarsfromGermany,ifthedealermustpayin ,thedealerisexposedtochangesinthe$/ exchangerate.Ifthe increaseinvalue relativetothe$.Thedealerwillhavetopaymore$for (andthereforeforthecars).

FinancialInstruments

39

Useofderivativesforrisk management
Commonexamplesofderivativeusedfor differenttypesofriskmanagementare Option(callorput)..OTCorTraded Forwards Futures SWAPs&SWAPtion
FinancialInstruments 40

Types explained
OPTIONS
Thesegivethe holdertheright, right but nottheobligation,to buyorsellaspecific underlyingasseton orbeforeaspecified f t date future d t at ta specifiedprice

FORWARDS
Theholderofa forwardcontractis obligedtobuyorsell adefinedamountof aspecificunderlying asset,ataspecified price i at taspecified ifi d futuredate. Forexample,a forwardcontractfor g currency y foreign mightrequire 100,000tobe exchangedfor $150,000inthree monthstime. time Both partiestothe contracthavebotha financialassetanda financialliability.

FUTURES
Futurescontracts obligetheholderto buyorsella standardquantityof aspecificunderlying itemataspecified f t date. future d t Futurescontractsare verysimilarto forwardcontracts. Thedifferenceisthat futurescontracts havestandardterms andaretradedona financialexchange, whereasforward contractsaretailor madeandarenot tradedonafinancial exchange

SWAPS
Twopartiesagreeto exchangeperiodic paymentsat specifiedintervals overaspecifiedtime period. Forexample,inan interestrateswap, thepartiesmay agreetoexchange fixedandfloating g rateinterest paymentscalculated byreferencetoa notionalprincipal amount amount.

FinancialInstruments

41

Checkit!!

FinancialInstruments

42

Embeddedderivative
Definition IAS39definesanembeddedderivativeasa componentofahybrid(combined)instrument thatalsoincludesanonderivativehost contract. contract
Anexampleisaninvestmentinaconvertibledebt instrumentwhichcombinesasinterestbearing debtinstrument(anonderivative),withanoption onequityshares(aderivative).
FinancialInstruments 43

EmbeddedDerivative
Whateffectdoesithave? When Wh aderivative d i ti is i embedded b dd din i anonderivative d i ti host h tcontract, t t the th embedded b dd dd derivative i ti causes someorallofthefairvalueofthecontract,orthecashflowsthatotherwisewouldberequiredby thecontract,tochangebasedonaspecifiedinterestrate,securityprice,commodityprice,foreign exchangerate,indexofpricesorrates,orothervariable.Forexample,thefairvalueofconvertible debtisnotthesameasthefairvalueofasimilardebtinstrumentwithouttheembedded conversionoption Howtheembeddedderivativeisworks Standalone(noneembedded)derivativesaremeasuredatfairvaluewithfairvaluegainsand lossestakenimmediatelytotheincomestatementunlesstheyaredesignatedashedging instrumentsinahedgingrelationship. instruments relationship IncertaincasesIAS39alsorequiresembeddedderivativestobeseparatelyaccountedforatfair valuethroughprofitandloss. Howtheembeddedderivativeisseparatelyaccountedfor? Theembeddedderivativeisfairvaluedfirstandthedifferencebetweenthefairvalueofthehybrid contractandthefairvalueoftheembeddedderivativeisassignedtothehost. Subsequentlythemeasurementofthehostcontractisdeterminedisdeterminedbytherelevant accountingstandardandclassificationwhiletheembeddedderivativeiscarriedatFVTPL.

FinancialInstruments

44

SeparationConditions
Herearetheconditionsthatmustbemetifanembeddedderivativeistobeseparatedfromitshost contractandaccountedforasstandalonederivative. Condition1 Thehybrid(combined)instrumentisnotmeasuredatfairvaluewithchangesinfairvaluereported inprofitorloss.Assumingtheembeddedderivativemustbeseparatelyaccountedfor,itwill alreadybeheldatfairvalueonthebalancesheet.Withchangesinfairvaluetakenthroughthe incomestatement. statement Ifthoughentirecontractisalreadybeingaccountedforinthisway, way thereisno needtoseparateouttheembeddedderivative. Condition2 Aseparateinstrumentwiththesametermsastheembeddedderivativewouldmeetthedefinition ofaderivative. C diti 3 Condition Theeconomiccharacteristicsandrisksoftheembeddedderivativearenotcloselyrelatedtothe economiccharacteristicsandrisksofthehostcontract. Imp. yisrequired q toaseparate p anembeddedderivativefromitshostcontractby yIAS39, ,butis Ifanentity unabletomeasureitseparatelyeitheratacquisitionorsubsequently,thenthefairvalueofthe embeddedderivativeisthedifferencebetweenthefairvaluesofthecombinedcontractandfair valueofthehostcontract,ifdeterminable. Iffairvalueofthehostcontractisnotdeterminable,theentitymusttreattheentirecombined g p profitorloss. contractasafinancialinstrumentatfairvaluethrough

FinancialInstruments

45

Checkit!!
Acompanyinvestsinaconvertibledebt instrumentatacostof$25,000.Thefixedinterest rateis7%anditcanbeconvertedintoordinary y sharesin10yearstime,atthecompanysoption, or,thecapitalcanberepaidat$25,000.The investmentisclassifiedasavailableforsale.The fairvalueoftheoptionisestimatedtobe$3,250 Suggestthecorrectaccountingtreatmentandpass necessaryjournalentries.
FinancialInstruments 46

FinancialInstruments Hedge Accounting


1. 1 2. 3 3. 4. 5. 6 6. TheBasics HedgedItems Hedging d i Instruments CashFlowHedge FairValueHedge Hedgesofnetinvestmentinforeign operations
FinancialInstruments 47

TheBasics
Hedgeaccountingisamethodofpresentationthatmaybe voluntarilyappliedtohedgingtransaction. Companiesoftenenterintoahedgingtransactionsto reducetheirriskexposure.Hedgingtransactionneutralize orreducethevariabilityinfairvalueorcashflowsthatarise fromtherisks. TheobjectiveofHedgeAccountingistoensureconsistent timingofrecognitionofgainsorlossesintheprofitorloss onthehedginginstrumentandonthehedgeitem. Inotherwordshedge g accounting gachievesmatching g in thetimingofrecognitionofgainsorlossesintheprofitor loss.

FinancialInstruments

48

RiskExposures
SEplc, AGBPfunctional company,hasafirm commitmentinsix monthstimeto purchaseanitemof machineryforafixed amountinUS$. TheRisk SEhasaforeign exchangeexposureto theUS$.ThecosttoSE inGBPofthefutureUS $purchasewillvary withtheUS$/GBP exchangerate HBPLC HBplchasvariablerate debt(LIBOR+2%) TheRisk HBisexposedto variabilityinitscash outflowsonitsfuture payments,whichwill varywithLIBORinterest rateindex. LRPLC LRplchasanequity investmentinWVplc. TheRisk LRhasapriceorfair valueexposureonits equityinvestmentin WVplc.LRs LR sabilityto generatereturnsonits investmentinWVona futuresalewillvary withthemarketp price forWVplc.

FinancialInstruments

49

ReducingRiskExposure
SEplc SEentersintoa forwardcontract tobuyUS$for thesameamount andsame maturity t it asits it firmcommitment topurchasean itemofmachinery inUS$. HBplc HBentersintoa payfixed,receive floatinginterest rateswapwith thesamenominal amount tasit its variablerateloan andindexedto thesameindex (LIBOR)andwith thesamematurity asitsloan.
FinancialInstruments

LRplc LRpurchasesa putoptiontosell itsinvestmentin WorthyVentureat aspecifiedprice at taspecified ifi d futuredate.

50

Lackofoffset
ThefinancialinstrumentsthatSE,HBandLRentered intohedgetheirriskexposuresarederivatives. UnderIAS39allderivativesmustberecognizedinthe b l balance sheet h tat tfair f i value. l However,oftentheitemsthatthecompanieshedge areeithernotyetrecordedonthebalancesheetorare recorded,butnotmeasuredatfairvalue. Thereisamismatchinthetimingofrecognitionofthe gainsandlossesinprofitandloss. Thisiswherehedgeaccountingcomesin.
FinancialInstruments 51

AchievingOffset
Companiescanemployhedgeaccountingtoachieveoffsetinprofitorloss. Th arethree There th principal i i lmethods th d ort typesof fhedge h d accounting, ti which hi hachieve hi offsetindifferentways. 1. CashFlowHedgeAccounting recognizeschangesinthefairvalueofthehedging instrumentoutsideprofitorlossinequityand`recycle`themintotheincome statementwhenthehedgeditemaffectsprofitorloss. loss ThisisKnownasacashflowhedgebecauseitistheexposuretothevariabilityin futurecashflowsthatisbeinghedged. 2. FairValueHedgeAccounting adjuststherecognizedassetorliabilitythatisbeing hedgedformovementsinthehedgedrisksoastooffsetinprofitandlosschanges inthefairvalueofthehedginginstrument. Thisisreferredtoasafairvaluehedgebecauseitisthefairvalueofthedesigned riskthatisbeinghedged. 3 NetInvestmentHedges(otherwiseknownashedginganetinvestmentina 3. foreignoperation) Athirdandfinalcategoryofhedgeaccountingishedginganetinvestmentina foreignoperation.Thisisaccountedforsimilarlytoacashflowhedge.

FinancialInstruments

52

TheRequirementsofHedge Accounting
Therearetwoprincipalrequirementsthathavetobemettoachievehedge accounting. accounting HedgeEffectiveness Oneofthecriteriathatmustbemetforaneconomichedgetoqualifyforhedge accountingisthatitishighlyeffective.Ahedgeishighlyeffectiveifthechangesin thefairvalueorcashflowsofthehedgeditemattributabletothehedgedrisk risk,for example,duetochangesininterestratesorforeignexchangerates areoffsetby thechangesinfairvalueorcashflowsofthehedginginstrumentwithinarangeof 80125%. FormalDesignation IAS39onlyallowsanentitytoapplyhedgeaccountingifitspecificallydesignates thehedginginstrumentandthehedgeditemfromthepointintimewhenitwants tocommenceapplyinghedgeaccounting.Therearestrictcriteriathatmustbe g accounting grelationship ptoqualify q yforhedge g accounting. g metforeachhedge
Consistentwiththecompanysriskmanagementstrategy ProspectiveEffectiveness RetrospectiveEffectiveness Measurable,withineffectivenessquantifiedandrecognizedinprofitorloss

FinancialInstruments

53

HedgingPortion
Itispossibletodesignateonlyaportionofeitherthecashflowsorfairvalueofa financialinstrumentasthehedgeditem. item Letstaketheexampleofafiveyear6%fixedrateloanasset,whichhasnotbeen classifiedasHTM. 1 1. H d the Hedge h full f llfair f i value l of fthe h cash hflows fl onthe h loan, l in i other h words, d all llthe h contractualcashflows. 2. Hedgethefairvalueonaproportionoftheloan forexample,thefairvalueof 50%ofloan aproportionofallthecontractualcashflows. 3 3. H d the Hedge h fair f i value l onall llcash hflows fl due d tothe h impact i of faspecific ifi risk i konly l forexample,interestraterisk(ratherthanallrisks) 4. Hedgepartofthecashflowsduetoaspecificrisk forexample,designatethe impactofmovementsininterestrateson50%ofthecashflows(ahedgeofa specificriskonaproportionofallcashflows). flows) 5. Hedgethefairvaluemovementontheprincipalonly(ahedgeofaportionofthe cashflows). 6. Hedgethefairvaluemovementduetointerestraterisk(andnotallrisk)onthe principalonly. only
FinancialInstruments 54

Firmcommitmentsandforecast transactions
Whatsthedifference? Forecasttransactionsarealwayscashflowhedged,whereasfirmcommitmentsare generallyfairvaluehedged. Afirmcommitmentisabindingagreementfortheexchangeofaspecified quantityofresourcesataspecifiedpriceonaspecifiedfuturedateordates. Anexample A l is i alegally l ll binding bi di purchase h agreementtotake k delivery d li of f100,000 100 000 bushelsofcornon30September2007for$20perbushel. Acommitmentisbindingifitisenforceableeitherlegallyorotherwise otherwise.Tobe enforceable,theagreementshouldprovideforremediesthatareavailabletothe partiestothecontractintheeventofnonperformance.

FinancialInstruments

55

Firmcommitmentsandforecast transactions
A forecast o ecasttransactions t a sact o sis san a u uncommitted co ttedbut anticipatedfuturetransaction. p aforecastpurchase p of100,000 Forexample, bushelsofcorntobeusedinanentitys manufacturingprocessinOctober.Theforecastis id tifi di identified inMay. M AnException Ifanentity tit is i hedging h d i the th foreign f i exchange h risk i ki in afirmcommitment,thismaybeaccountedfor eitherasafairvalueoracashflowhedge. hedge
FinancialInstruments 56

HedgingInstrument
Ahedginginstrumentisnormallyaderivative derivative. Butforahedgeoftheriskofchangesin foreigncurrencyexchangeratesonly, only a hedginginstrumentcanbeanonderivative financialassetoranonderivativefinancial liability,whosefairvalueorcashflowsare expectedtooffsetchangesinthefairvalueor cashflowsofadesignatedhedgeditemso thatthehedgeditemiseffectivelyhedged hedged.
FinancialInstruments 57

CashFlowHedge
AcompanytradesinGBPItexpectstopurchaseapieceofplantfor 1million illi euros in i oneyearfrom f 1May M 20X6 20X6.I Inorder d t tooffset ff tth the riskofincreasesintheeurorate,thecompanyentersintoaforward contracttopurchase1millioneuros in1yearforafixedamount (GBP650,000). ( , ) Theforwardcontractisdesignated g asacashflow hedge.Atinception,theforwardcontracthasafairvalueofzero. Attheyearendof31October20X6,theeurohasappreciatedand thevalueof1millioneuros isGBP660 660,000. 000 Themachinewillstill cost1millioneuros sothecompanyconcludesthatthehedgeis 100%effective.Thustheentirechangeinthefairvalueofthe hedginginstrumentisrecognised directlyinreserves.
DrForwardcontract GBP.10,000 CrReserves GBP10,000

FinancialInstruments

58

CashFlowHedge
Theforwardcontractissettledwithnofurtherchangeintheexchange rate: t
DrCash GBP10,000 CrForwardcontract GBP10,000

Thecompanypurchasesthemachinefor1millioneuros andmakes thefollowingjournalentry: DrMachine GBP 660 GBP. 660,000 000 CrAccountsPayable RGBP.660,000 ThedeferredgainorlossofGBP. GBP 10,000 10 000shouldeitherremainin reservesandbereleasedfromequityasthemachinedepreciates,or bedeductedfromtheinitialcarryingamountofthemachine.

FinancialInstruments

59

FairValueHedge Anexample
Acompanypurchasesanequityinstrumentfor$.1million.Theinstrumentisnotheld fortradingandcompanydesignatedittobemeasuredatfairvaluewithchangestobe recognised trhough othercomprehensiveincome. Thecompanyisexposedtoapriceriskofthedeclineinthefairvalueofthe instrumentifthemarketbehaviorchanges.. Thecompanypurchasesputoptionsinordertooffsettheriskofadeclineinfairvalue. Anydeclineinthefairvalueoftheinstrumentshouldbeoffsetbyoppositeincreases inthefairvalueofthederivativeinstrument. Assumingmarketpricesofsharesfallto$960,000.TheinstrumentisclassifiedasFV changesinOCIthereforethedecreaseinfairvaluewouldnormallyberecorded directlyinreserves. However,sincetheinstrumentisahedgediteminafairvaluehedge,thischangein fairvalueoftheinstrumentwillberecognised inprofitorloss,ifhedgeiseffective.

FinancialInstruments

60

FairValueHedge
DrIncomestatement CrInvestmentinEquity $ 40,000 $. , $.40,000

Atthesametime,thecompanydeterminesthatthefair valueoftheputoptionshasincreasedby$.40,000.Since theswapisaderivative derivative,itismeasuredatfairvaluewith changesinfairvaluerecognised inprofitorloss. Thechanges g infairvalueofthehedged g itemandthe hedginginstrumentexactlyoffseteachother:thehedge is100%effectiveandtheneteffectonprofitorlossis zero. zero
FinancialInstruments 61

Disclosures

IFRS7FinancialInstruments: Disclosures l
IFRS7Financialinstruments:disclosures providesthedisclosurerequirementsforfinancial instruments.Asummaryoftherequirementsis detailedbelow. below Thetwomaincategoriesofdisclosuresrequired are:
1. informationaboutthesignificanceoffinancial instruments. 2 Informationaboutthenatureandextentofrisks 2. arisingfromfinancialinstruments. Thedisclosuresmadeshouldbemadebyeachclass offinancialinstrument
FinancialInstruments 63

OverviewofDisclosureRequirements
Significanceoffinancial instruments
Anentitymustdisclosethe significanceoffinancial instrumentsfortheirfinancial positionandperformance. Thedisclosuresmustbemade foreachclassoffinancial instruments. Anentitymustdiscloseitems ofincome,expense,gains,and losses,withseparate disclosureofgainsandlosses fromeachclassoffinancial instrument.

Natureandextentofrisksarisingfromfinancialinstruments
Qualitativedisclosures Thequalitativedisclosures describe: riskexposuresforeachtype offinancialinstrument managementsobjectives, policies,andprocessesfor managingthoserisks changesfromtheprior period i d Quantitativedisclosures Thequantitativedisclosures provideinformationaboutthe extenttowhichtheentityis exposedtorisk risk,basedon informationprovidedinternally totheentityskeymanagement personnel.Thesedisclosures include: summaryquantitativedata aboutexposuretoeachrisk atthereportingdate disclosuresaboutcreditrisk, liquidityrisk,andmarketrisk asfurtherdescribedbelow concentrationsofrisk.
64

FinancialInstruments

TypesofRisks
Marketrisk
Thisreferstothepossibilitythatthevalueofanasset(orburdenofaliability)mightgoupordown.Marketrisk includesthreetypesofrisk:currencyrisk,interestrateriskandpricerisk. Currencyriskistheriskthatthevalueofafinancialinstrumentwillfluctuatebecauseofchangesinforeign exchangerates. Fair F i value l interest i t trate t risk i kis i the th risk i kth that tthe th value l of fafinancial fi i linstrument i t twill illfluctuate fl t t d duet tochanges h i in marketinterestrates.Thisisacommonproblemwithfixedinterestratebonds.Thepriceofthesebondsgoesup anddownasinterestratesgodownandup. Pricerisk.Thisreferstootherfactorsaffectingpricechanges.Thesecanbespecifictotheenterprise(bad financialresultswillcauseasharepricetofall),relatetothesectorasawhole(allTechStocksboomedinthelate nineties, i ti and dcrashed h di inth thenewcentury) t )orrelate l t t toth thet typeof fsecurity it (b (bonds d d dowell llwhen h shares h ared doing i badly,andviceversa). Marketriskembodiesnotonlythepotentialforalosstobemadebutalsoforagaintobemade.

Creditrisk
Theriskthatonepartytoafinancial instrumentfailstodischargeits obligations,causingafinanciallossto theotherparty.Forexample,abankis exposedtocreditriskonitsloans, becauseaborrowermightdefaulton itsloan.

Liquidityrisk
Thisisalsoreferredtoasfundingrisk. Thisistheriskthatanenterprisewill beunabletomeetitscommitmentson itsfinancialinstruments.Forexample, abusinessmaybeunabletorepayits loanswhentheyfalldue.

Cashflowinterestraterisk
Thisistheriskthatfuturecash flowsassociatedwithamonetary financialinstrumentwillfluctuate inamountduetochangesin marketinterestrates.Forexample, thecashpaid(orreceived)on floatingrateloanswillfluctuatein linewithmarketinterestrates.

FinancialInstruments

65