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Chapter 15

Accounting for financial instruments


15.1

AASB 132 Financial Instruments: Disclosure and Presentation defines a financial instrument
as any contract that gives rise to both a financial asset of one entity and a financial liability or
equity instrument of another entity. Such a definition, in turn, generates a need to define a
financial asset; a financial liability; and, an equity instrument.
According to paragraph 11 of AASB 132, financial asset means any asset that is:
(a)
cash;
(b)
an equity instrument of another entity;
(c)
a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or
(d)
a contract that will or may be settled in the entitys own equity instruments and
is:
(i) a non-derivative for which the entity is or may be obliged to receive a
variable number of the entitys own equity instruments; or
(ii) 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 entitys
own equity instruments. For this purpose the entitys own equity instruments
do not include instruments that are themselves contracts for the future
receipt or delivery of the entitys own equity instruments.
A financial liability, on the other hand, means any liability that is
(a)

(b)

a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or
a contract that will or may be settled in the entitys own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entitys own equity instruments; or
(ii) 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 entitys own
equity instruments. For this purpose the entitys own equity instruments do not
include instruments that are themselves contracts for the future receipt or delivery
of the entitys own equity instruments.

If a financial instrument does not give rise to a contractual obligation on the part of the issuer
to deliver cash or another financial asset, or to exchange another financial instrument under
conditions that are potentially unfavourable, then it is considered to be an equity interest
where equity is defined as the residual interest in the assets of the entity after deduction of its
liabilities.
15.2

Examples of primary financial instruments would include receivables, payables and equity
securities. Primary financial instruments generate rights and obligations between the parties
directly involved in the underlying transaction. For example, acquiring shares in a company
gives the investor a financial asset in the company and the shares are considered an equity
instrument of the company. Acquiring inventory on credit from a company gives the selling

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company a financial asset (a right to cash), and the purchaser a financial liability (an
obligation to deliver cash to the company).
15.3

Derivative financial instruments have been defined as instruments which create rights and
obligations that have the effect of transferring one or more of the financial risks inherent in an
underlying primary financial instrument, and the value of the contract normally reflects
changes in the value of the underlying financial instrument (International Accounting
Standards Committee, Exposure Draft 40: Financial Instruments). This is consistent with the
description provided at paragraph AG 16 of AASB 132 which states:
Derivative financial instruments create rights and obligations that have the effect of
transferring between the parties to the instrument one or more of the financial risks
inherent in an underlying primary financial instrument. On inception, derivative
financial instruments give one party a contractual right to exchange financial assets
or financial liabilities with another party under conditions that are potentially
favourable, or a contractual obligation to exchange financial assets or financial
liabilities with another party under conditions that are potentially unfavourable.
However, they generally do not result in a transfer of the underlying primary
financial instrument on inception of the contract, nor does such a transfer
necessarily take place on maturity of the contract. Some instruments embody both
a right and an obligation to make an exchange. Because the terms of the exchange
are determined on inception of the derivative instrument, as prices in financial
markets change, those terms may become either favourable or unfavourable.
Derivative financial instruments would include financial options, futures, forward contracts
and interest rate or currency swaps.

15.4

The value of a derivative is directly related to another underlying item. For example, a share
option - which is a derivative - derives its value from the market value of the underlying
shares. Derivative financial instruments create rights and obligations that have the effect of
transferring one or more of the financial risks inherent in the underlying primary financial
instrument. According to paragraph 9(a) of AASB 139, the value of a derivative:
changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit
rating or credit index, or other variable, provided in the case of a non-financial
variable that the variable is not specific to a party to the contract (sometimes
called the underlying);
In relation to the measurement of derivative financial instruments there is a general
requirement, as provided in AASB 139, that financial instruments are to be measured at fair
value. As with financial instruments generally, all derivatives are required to be recognised
and measured at fair value. Gains and losses on the financial instruments would generally go
directly to the profit and loss account. However, this will be influenced by whether there is an
associated hedge that has been designated as a hedge and that has been deemed to be
effective.
Where there is a designated cash-flow hedge the gain or loss on the hedging instrument
(for example, a futures contract) is initially recorded in equity. It can subsequently be
transferred to profit and loss so as to offset the impact on profit or loss of any change in
value of the hedged item (for example, an amount owing to an overseas supplier).
Where an item is designated a fair value hedge the change in value of the hedged item and
the change in value of the hedging instrument are both immediately recognised in profit or
loss.

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15.5

A call option gives the holder of the option a right to buy a specific item (for example, shares
in a particular company) at a future time for a pre-specified price. This price is usually
described as either the exercise price, or the strike price. Once the exercise price is
determined it will remain fixed regardless of variations in the market price of the underlying
item. To the extent that the option can be traded, the sale price of the option would fluctuate
as the value of the underlying item changes, with an increase in the price of the underlying
item leading to an increase in the price of the option (and vice versa).
A put option on shares entitles the holder of the option to require another party to buy a
given quantity of a specific item (for example, shares) at a future date for a pre-specified
price. The value of the put option will also be dependent upon the market price of the
underlying asset.

15.6

A compound instrument is a financial instrument that contains both a financial liability, and an
equity element. There is a requirement that the debt and equity components of a compound
instrument be accounted for separately. Compound instruments include such things as
convertible notes. As paragraph 29 of AASB 132 states, the economic effect of issuing a
compound instrument is:
substantially the same as issuing simultaneously a debt instrument with an early
settlement provision and warrants to purchase ordinary shares, or issuing a debt
instrument with detachable share purchase warrants. Accordingly, in all cases, the
entity presents the liability and equity components separately on its balance sheet.
When the initial carrying amount of a compound financial instrument is allocated to its equity
and liability components, the equity component is assigned the residual amount after
deducting from the fair value of the instrument as a whole the amount separately determined
as the fair value of the liability component.

15.7

Mark to market means that particular assets will be valued on the basis of their net market
value, that is, their current selling prices less the costs that will arise in making such a sale.
When assets are marked to market it is normal for any gain or loss in the value of the assets
to be treated as part of the periods profit or loss (that is, as a revenue or expense item).

15.8

There are four categories of financial instruments identified in paragraph 9 of AASB 139 and
each category is assigned a measurement principle. The four categories are:
1. financial asset or financial liability at fair value through profit or loss;
2. held-to-maturity investments;
3. loans and receivables; and
4. available-for-sale financial assets.
Paragraph 46 of AASB 139 provides the rules for subsequent measurement of the various
classes of financial instrument where it states:

After initial recognition, an entity shall measure financial assets, including


derivatives that are assets, at their fair values, without any deduction for
transaction costs it may incur on sale or other disposal, except for the following
financial assets:
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(a) loans and receivables as defined in paragraph 9, which shall be measured at


amortised cost using the effective interest method;
(b) held-to-maturity investments as defined in paragraph 9, which shall be
measured at amortised cost using the effective interest method; and
(c) investments in equity instruments that do not have a quoted market price in an
active market and whose fair value cannot be reliably measured and
derivatives that are linked to and must be settled by delivery of such unquoted
equity instruments, which shall be measured at cost (see Appendix A
paragraphs AG80 and AG81).
The above requirements refer to held-to-maturity investments. Held-to-maturity investments
are defined at paragraph 9 of AASB 139 as non-derivative financial assets with fixed or
determinable payments and fixed maturity that an entity has the positive intention and ability
to hold to maturity. A held-to-maturity investment would include a bond issued by another
entity that pays interest at a fixed rate each year and stipulates a specific time at which the
borrowing entity agrees to repay (redeem) the amount borrowed (often described as a fixed
rate debenture). Amortised cost, as also referred to in the paragraph just quoted, is defined at
paragraph 9 of AASB 139 as follows:
The amortised cost of a financial asset or financial liability is the amount at which
the financial asset or financial liability is measured at initial recognition minus
principal repayments, plus or minus the cumulative amortisation using the effective
interest method of any difference between that initial amount and the maturity
amount, and minus any reduction (directly or through the use of an allowance
account) for impairment or uncollectibility.
The effective-interest method is also referred to in paragraph 46 just quoted. AASB 139
provides the following definition of effective-interest method:
The effective interest method is a method of calculating the amortised cost of a
financial asset or a financial liability (or group of financial assets or financial
liabilities) and of allocating the interest income or interest expense over the
relevant period. The effective interest rate is the rate that exactly discounts
estimated future cash payments or receipts through the expected life of the financial
instrument or, when appropriate, a shorter period to the net carrying amount of the
financial asset or financial liability.
15.9

Swaps occur when borrowers exchange aspects of their respective loan obligations. Foreign
currency swaps occur when the obligation related to a loan denominated in one currency is
swapped for a loan denominated in another currency.
If an organisation has receivables and payables that are both denominated in another
particular foreign currency, then changes in the spot rates will create gains on one, but losses
on the other. To the extent that the receivable and payables are for the same amount and
denominated in the same currency, the losses on one monetary item (perhaps the foreign
currency payable) will be offset by gains on the other monetary item (perhaps the foreign
currency receivable).
If a particular organisation has a number of receivables that are denominated in a foreign
currency then changes in spot rates may potentially create sizeable foreign currency gains, or
sizeable foreign currency losses. If that same organisation does not have any payables
denominated in the same currency then it will be exposed to potential gains and losses. If it is

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able to convert some of its domestic loans into foreign currency loans, of the same
denomination as its receivables, then it will be able to effectively insulate or hedge itself from
the effects of changes in spot rates. A gain on one will effectively offset the loss on the other.
Such an organisation may seek to find another entity that is prepared to swap its foreign
currency loans for the organisations domestic loans.
15.10 When an interest rate swap occurs, one party exchanges its interest payments of a specified
amount with another party. This generally involves swapping one stream of interest payments
which are charged at a variable or floating rate with another stream of interest payments
which are of a fixed amount. For a swap to proceed, both parties to the swap will need to
receive benefits in the form of reductions in total interest payments. They will be able to
achieve savings in interest expenses and be able to obtain their preferred terms; for example,
a fixed interest obligation or a variable interest obligation.
15.11 A futures contract is a contract to buy or sell an agreed quantity of a particular item, at an
agreed price, on a specific date. Substantial gains or losses can be made given that typically
only a small deposit is made on the contract. For example, a deposit of 5 per cent may be
made on a futures contract that requires the delivery of a commodity for a fixed price of
$1 million. If the price of the commodity rises to $1.05 million (a modest increase of 5 per
cent) the futures trader has lost $50 000 on the contract (the trader is locked in to receiving
only $1 million for an asset that can be acquired on the market for $1.05 million)that is, the
trader has lost the entire amount of the deposit as a result of a 5 per cent rise in the price of
the commodity.
15.12 Reef Ltd would take a sell position on the portfolio (perhaps by investing in share price
index futures or in futures of the specific companies in the portfolioto the extent futures
are available on these specific companies). If the price of the underlying shares falls then Reef
Ltd has entered into a contract to sell the assets for a particular price which is higher than the
current market value. This results in a gain on the contract. The gain on the futures contract
will offset the loss on the share portfolio held by Reef Ltd.
15.13 AASB 132 requires that the issuer of a compound financial instrument present the compound
instrument in two parts, these parts being the equity component and the liability component.
Probabilities are not to be taken into account, and the classification of the security is not to
be revised as probabilities of conversion, or otherwise, change across time. Specifically,
paragraph 30 of AASB 132 states:
Classification of the liability and equity components of a convertible instrument is
not revised as a result of a change in the likelihood that a conversion option will be
exercised, even when exercise of the option may appear to have become
economically advantageous to some holders.
The classification of the securities can only change if a transaction or other specific action by
the issuer or holder of the instrument alters the substance of the financial instrument.
By contrast to the accounting standards, the AASB Framework takes into account the
probabilities, as at reporting date, that a particular transaction will occur. For example, if
convertible notes have been issued by a company and at reporting date it appears probable
(more likely than less likely) that the notes will be converted to shares then the convertible
notes would be disclosed as equity. However, as indicated above, regardless of probabilities,
AASB 132 would require the convertible notes to be disclosed with both an equity and
liability component.

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Students should be encouraged to consider the conceptual validity of both alternatives. The
conceptual approach of the AASB Framework does appear to have some merit.
15.14 Where interest is incurred in undertaking such activities as constructing assets, AASB 132
does not preclude the entity from treating such costs as part of the cost of the asset under
construction. Where interest is treated as part of the cost of an asset under construction, such
interest would ultimately be treated as an expense either in the form of cost of goods sold, or
as part of an increased depreciation charge.
AASB 123 Borrowing Costs provides further requirements. Pursuant to AASB 123,
borrowing costs must be recognised as an expense in the financial year in which they are
incurred, except that borrowing costs that are directly attributable to the acquisition,
construction or production of a qualifying asset must be capitalised as part of the cost of that
asset. Borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset must be determined as those borrowing costs which would
have been avoided if the expenditure on the qualifying asset had not been made.
Examples of qualifying assets are inventories that require a substantial period of time to bring
them to a saleable condition, assets resulting from development and construction activities in
the extractive industries, manufacturing plants, power generation facilities and investment
properties. Other investments, and those inventories that are routinely manufactured or
otherwise produced in large quantities on a repetitive basis over a short period of time, are
not qualifying assets. Assets that are ready for their intended use or sale when acquired are
not qualifying assets.
A substantial period of time, referred to in the definition of qualifying asset, is generally
regarded as more than 12 months from the time activities that are necessary to prepare the
asset for its intended use or sale are in progress to the time when substantially all such
activities are complete.
15.15 Yesin certain circumstances it could bebut it depends upon the nature of the preference
shares. If preference shares are deemed to be debt (perhaps they provide for redemption at
the option of the holder and provide cumulative dividends at a fixed rate) then the associated
periodic payments would be treated as interest rather than dividends. As paragraph 36 of
AASB 132 states:
The classification of a financial instrument as a financial liability or an equity
instrument determines whether interest, dividends, losses and gains relating to that
instrument are recognised as income or expense in profit or loss. Thus, dividend
payments on shares wholly recognised as liabilities are recognised as expenses in
the same way as interest on a bond. Similarly, gains and losses associated with
redemptions or refinancings of financial liabilities are recognised in profit or loss,
whereas redemptions or refinancings of equity instruments are recognised as
changes in equity.
15.16 What this means is that it does not matter what the security is actually called. If there is a
contractual obligation on one party to deliver cash or another financial asset, or to exchange
another financial instrument under conditions that are potentially unfavourable, then that
entity has a liability in existence.
15.17 As its name would suggest, Accounting Standard AASB 7 Financial Instruments: Disclosure
provides the disclosure requirements relating to financial instruments. In explaining the
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rationale for the disclosure requirements within AASB 7, paragraphs 1 and 2 of AASB 7
state:
1

The objective of this Standard is to require entities to provide disclosures in their


financial report that enable users to evaluate:
(a) the significance of financial instruments for the entitys financial position and
performance; and
(b) the nature and extent of risks arising from financial instruments to which the
entity is exposed during the period and at the reporting date, and how the
entity manages those risks.

The principles in this Standard complement the principles for recognising,


measuring and presenting financial assets and financial liabilities in AASB 132
Financial Instruments: Presentation and AASB 139 Financial Instruments:
Recognition and Measurement.

The disclosure requirements within AASB 7 are extensive. In part, the relatively large number
of disclosure requirements is probably a direct consequence of the significant losses many
organisations have incurred recently in relation to financial instruments or, more particularly,
derivative financial instruments, a notable case being the collapse of the UK merchant bank,
Barings plc., and in the Australian context, National Australia Bank. Such losses make
investors wary and inclined to demand greater disclosures about such instruments.
AASB 7 specifies numerous disclosures that entities must make in relation to all financial
instruments (to the extent that such information is considered to be material to the users of
the entitys reports). While there are many specific disclosure requirements in the standard,
some general principles are also provided at paragraphs 7 and 31 of AASB 7. These
paragraphs state:
7

An entity shall disclose information that enables users of its financial report to
evaluate the significance of financial instruments for its financial position and
performance.

31

An entity shall disclose information that enables users of its financial report to
evaluate the nature and extent of risks arising from financial instruments to
which the entity is exposed at the reporting date.

15.18 (a)

Convertible bonds would be classified as compound financial instruments as they


would typically contain both a financial liability and equity component. AASB 132
requires that the debt and equity components of a compound instrument shall be
disclosed separately. Hence, the approach described within the questions would not
be permitted under AASB 132.

(b)

This is an interesting issue which should be used to stimulate debate. In most cases,
the liability component of the compound instrument will constitute the major
proportion of the total book value of the instrument. If an entity iss required to
disclose this component as a liability as is now the case, rather than below the total
of shareholders equity, this will have obvious implications for its gearing ratios. If
some of these ratios are applied in contractual arrangements that the firm is party to
then this could have real implications for the cash flows of the entity. Further,
depending upon ones perspective about the efficiency of the capital market,
classifying a component of the compound instruments as liabilities may increase the

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risk of the entity, as perceived by the market. This could in turn have implications for
the entitys cost of capital.
15.19 (a)

By entering the forward rate agreement with the bank, Lehman Ltd has a guarantee
from the bank relating to how much it will receive in exchange for US$500 000.
Lehman Ltd will receive A$694 444 (500 000 0.72) for the printed material
regardless of what happens to the exchange rate. That is, Lehman Ltd will not be
subject to any risk that the amount it will receive will decrease (or increase). In
exchange for reducing the risk, the bank effectively charges Lehman Ltd a fee of
(500 000 0.70) (500 000 0.72), which equals $19 842. The greater the
difference between the spot rate and the forward rate, the greater the amount that is
being charged by the bank.

(b)

Lehman will receive A$694 444 from the sale (500 000 0.72), regardless of any
fluctuations in the exchange rate.

15.20 The price of Skeg Ltd Futures is $9.70 when Dorothy Wax enters the futures contract.
Hence, regardless of what happens to the market price of the futures contract, Dorothy has
locked in the price that she will ultimately receive.
After the passing of one month the price of Skeg Ltd shares has risen from $9.50 to $12.10,
and the futures price has risen from $9.70 to $12.29. Dorothy has made a loss on the futures
contract as she has an agreement to sell the futures at a price of $9.70, which is well below
their current market price. The loss on the futures contract amounts to $2.59 x 10 000, which
equals $25 900. This loss offsets the gain of $26 000 (10 000 x $2.60) that she has made on
the underlying securitythe shares in Skeg Ltd.
Dorothy effectively hedged the amount she would ultimately receive. In total, she will
receive:
From the shares in Skeg Ltd:
Amount payable to futures broker to cover losses:
Net amount received from investments

10 000 x $12.10
10 000 x $2.59

$121 000
$25 900
$95 100

The net amount received from the investments is approximately the same amount Dorothy
would have received had she been able to sell the shares in Skeg Ltd one month earlier (this
is the objective of entering into the futures contract). At that time she would have received
$95 000 (10 000 x $9.50). As things turned out, Dorothy would have been better placed had
she not entered the futures contract (she would have received $121 000 in total)but things
could obviously have moved in the opposite direction and had she not entered the futures
contract she may have got much less money than $95 000.
15.21 The options contract establishes a financial instrument that gives Holder Ltd the right to
acquire 100,000 shares in Torquay Ltd for $10.00 a share, and creates an obligation for
Issuer Ltd to sell 100,000 shares in Torquay Ltd to Holder Ltd for $10.00 a share.
From Holder Ltds perspective it has a financial asset. The contract gives Holder Ltd the right
to exchange financial assets (cash for shares) under conditions that are potentially favourable.
Should the price of Torquay Ltds shares increase beyond $10.00, Holder Ltd would exercise
the options and make a profit. The worst case scenario for Holder Ltd would be the shares in
Torquay Ltd not increasing beyond $10.00 (they would be out of the money) and Holder Ltd
letting the options lapse.
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From Issuer Ltds perspective, it has a financial liability. Issuer Ltd has entered a contract to
exchange financial assets (shares for cash) under conditions that are potentially unfavourable
to the entity. For example, if the shares in Torquay Ltd increase to $11.00, Issuer Ltd will be
required to acquire 100,000 shares from the market for $11.00 each and sell them to Holder
Ltd for $10.00 each.
If the price of Torquay shares falls to $5.00 per share then we would imagine that this might
mean that it is unlikely that the options will be exercised in the future. However, this does not
mean that a financial liability should not be recognised by Issuer Ltd. Paragraph AG17 of
AASB 132 notes that likelihood of the option being exercised does not impact on its
classification as a financial liability. Paragraph AG17 states:
A put or call option to exchange financial assets or financial liabilities (i.e.
financial instruments other than an entitys own equity instruments) gives the
holder a right to obtain potential future economic benefits associated with changes
in the fair value of the financial instrument underlying the contract. Conversely, the
writer of an option assumes an obligation to forgo potential future economic
benefits or bear potential losses of economic benefits associated with changes in
the fair value of the underlying financial instrument. The contractual right of the
holder and obligation of the writer meet the definition of a financial asset and a
financial liability, respectively. The financial instrument underlying an option
contract may be any financial asset, including shares in other entities and interest
bearing instruments. An option may require the writer to issue a debt instrument,
rather than transfer a financial asset, but the instrument underlying the option
would constitute a financial asset of the holder if the option were exercised. The
option-holders right to exchange the financial asset under potentially favourable
conditions and the writers obligation to exchange the financial asset under
potentially unfavourable conditions are distinct from the underlying financial asset
to be exchanged upon exercise of the option. The nature of the holders right and of
the writers obligation are not affected by the likelihood that the option will be
exercised.
15.22 Accounting entries in the books of Billy Ltd
1 July 2009
Dr
Cr

Cash
Foreign loan payable

2 142 857
2 142 857

To recognise, at the 1 July 2009 spot rate, the initial loan received from the US company.
(2 142 857 = 1 500 000 0.70)
Dr
Cr

Foreign currency receivable


Australian loan

2 142 857
2 142 857

To recognise the swap with Rip Ltd of the foreign currency loan, for the loan denominated in
Australian dollars. It is assumed that the swap is for the amount of $2 142 857, which is the
lower amount of the two loans taken out by Billy Ltd and Rip Ltd (denominated in Australian
dollars). Billy Ltd now has a foreign loan and a foreign currency receivable. The foreign
currency receivable has arisen because Rip Ltd has agreed to take responsibility for the
overseas loan in exchange for Billy Ltd taking responsibility for the Australian loan. That is,
Billy Ltd has a claim against Rip Ltd (a receivable) for an amount equivalent to the amount
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borrowed from the US bank. As Billy Ltd has both a payable and a receivable that are of the
same amount and denominated in the same foreign currency, it is effectively insulated from
any foreign currency gains or losses that may result from changes in the exchange rates.
30 June 2010
Dr
Cr

Foreign exchange loss (an expense)


Foreign loan payable

95 949
95 949

(To recognise the loss on the loan with the US corporation. At reporting date, foreign
currency receivables and foreign currency payables must be converted to Australian dollars
using the exchange rate in place at reporting date. Any change in the amount of the foreign
currency receivable or payable will be treated as part of the periods profit or loss)
Value of loan as at 1 July 2009:
Value of loan as at 30 June 2010:
Dr
Cr

1 500 000 0.70 = 2 142 857


1 500 000 0.67 = 2 238 806
95 949

Foreign currency receivable


Foreign exchange gain (a revenue)

95 949
95 949

(To recognise the gain on the receivable with Rip Ltd.)


Value of receivable as at 1 July 2009:
Value of receivable as at 30 June 2010:

1 500 000 0.70 = 2 142 857


1 500 000 0.67 = 2 238 806
95 949

As can be seen, as the risk of the foreign currency exposure has been shifted fully to Rip Ltd,
Billy Ltd does not record any net foreign currency gains or losses as the losses on the payable
are offset by the gains on the receivable.
Dr
Cr

Interest expense
Cash

134 328
134 328

134 328 = (1 500 000 x 0.06) 0.67


(To recognise the payment made to the US corporation.)
Dr
Cr

Cash
Interest revenue

27 185
27 185

Billy Ltd initially has to make the payment to the US company for the funds it borrowed.
That is, even in the presence of the agreement with Rip Ltd, Billy Ltd will still comply with
its contractual commitment with the overseas capital supplier. However, Rip Ltd has agreed
to take responsibility for the overseas loan, whilst Billy Ltd agreed to take responsibility for
Rip Ltds domestic loan. The interest payment on the amount of the Australian loan that has
actually been swapped is $107 143 (that is, $2 142 857 x 5%). Billy Ltd will expect to
receive $27 185 ($134 328 $107 143) from Rip Ltd, such that Billy Ltds total interest
expense ($134 328 $27 185) is that which is payable on the swapped portion of the
domestic loan ($107 143)the loan for which it has agreed to take responsibility.
In the books of Rip Ltd
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1 July 2009
Dr
Cr

Cash
Loan

2 200 000
2 200 000

To recognise the domestic loan taken out by Rip Ltd.


Dr
Cr

Loan receivable
Foreign currency payable

2 142 857
2 142 857

(To recognise the swap of the domestic loan obligations for the foreign loan obligations of
Billy Ltd [1 500 000 0.7].)
30 June 2010
Dr
Cr

Foreign exchange loss


Foreign currency payable

95 949
95 949

Rip Ltd has recorded a loss as a result of taking on the responsibilities of Billy Ltds US loan.
But, as indicated earlier, the reason Rip Ltd sought to take responsibility for the US loan was
that it had receivables that were denominated in US dollars. Adjustments to the value of these
receivables (not shown in this solution due to lack of information) will offset, fully or
partially, the losses on the overseas loan.
Value of payable as at 1 July 2009:
Value of payable as at 30 June 2010:
Expense
Dr
Cr

Interest expense
Cash

1 500 000 0.70 =


2 000 000 0.67 =

2 142 857
2 238 806
95 949
107 143
107 143

(To recognise the interest payment made by Rip Ltd on the swapped portion of the domestic
loan. Rip Ltd will also have another smaller payment [totalling $2 857] for the unswapped
portion which we have not shown here. As per the swap agreement, Billy Ltd will take
responsibility for the domestic loan commitments.)
107 143 = 2 142 857 x 5%
2 857 = (2 200 000 2 142 857) x 5%
Dr
Cr

Interest expense
Cash

27 185
27 185

An adjustment payment between Rip Ltd and Billy Ltd is made such that in total Rip Ltd will
make payments equivalent to the interest on the overseas loan (the loan it has taken
responsibility for as part of the swap).
Cash flows associated with domestic loan: 2 142 857 x 5% =
Cash flows associated with overseas loan:
(1 500 000 x 6%) 0.67
Amount to be transferred from Rip Ltd to
Billy Ltd
15.23 (a)

$107 143
$134 328
$ 27 185

A hedging transaction occurs when an entity enters an agreement that takes a position
opposite to the original transaction. Hedge accounting is undertaken to account for

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(b)

the hedging transaction. The purpose of hedge accounting is described at paragraph


85 of AASB 139 and is to recognise the offsetting effects on profit or loss of changes
in the fair values of the hedging instrument and the hedged item. According to
paragraph 86 of AASB 139 there are three main types of hedges, these being:
fair value hedges;
cash-flow hedges; and
hedges of net investments in a foreign operation.
Hedging instruments and hedged items are defined in AASB 139 as follows:

A hedging instrument is a designated derivative or (for a hedge of the risk of changes


in foreign currency exchange rates only) a designated non-derivative financial asset or
non-derivative financial liability whose fair value or cash flows are expected to offset
changes in the fair value or cash flows of a designated hedged item (paragraphs 7277
and Appendix A paragraphs AG94AG97 elaborate on the definition of a hedging
instrument).
A hedged item is an asset, liability, firm commitment, highly probable forecast
transaction or net investment in a foreign operation that (a) exposes the entity to risk
of changes in fair value or future cash flows and (b) is designated as being hedged
(paragraphs 7884 and Appendix A paragraphs AG98AG101 elaborate on the
definition of hedged items).
(c) For a fair value hedge, paragraph 89 of AASB 139 requires both the hedged item and the
hedging instrument to be valued at fair value with any gains or losses due to the fair
value adjustments to be treated as part of the periods profit or loss. If the gains or losses
on the hedged item are perfectly hedged then the gains or losses on the hedging
instrument will offset the gains or losses on the hedged item such that the net effect on
the periods profit or loss could be $nil.
For a cash flow hedge, the gain or loss on measuring the hedged item at fair value is to
be treated as part of the periods profit or loss. The gain or loss on the hedging
instrument is to be initially transferred to equity, but subsequently transferred to the
income statement as necessary to offset the gains or losses recorded on the hedged item.
At the conclusion of the hedging arrangement, any amount still in equity as relating to
the hedging instrument shall be transferred to the income statement.
In relation to hedges of a net investment in a foreign operation, including a hedge of a
monetary item that is accounted for as part of the net investment (see AASB 121),
paragraph 102 of AASB 139 requires that the hedge shall be accounted for similarly to
cash flow hedges. Specifically:
(i)
(ii)

the portion of the gain or loss on the hedging instrument that is determined to be
an effective hedge (see paragraph 88) shall be recognised directly in equity
through the statement of changes in equity (see AASB 101); and
the ineffective portion shall be recognised in profit or loss. The gain or loss on the
hedging instrument relating to the effective portion of the hedge that has been
recognised directly in equity shall be recognised in profit or loss on disposal of
the foreign operation.

15.24 On 29 July the All Ordinaries SPI has increased to 2720 and the value of the organisations
share portfolio has increased to $1 725 000. The total gain or loss after hedging can be
calculated as:
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Gain on share portfolio:


Market price at 1 July 2009:
Market price at 29 July 2009:

$1 550 000
$1 725 000

$175 000

Loss on SPI futures:


Price on 1 July 2009: 2500 x $60 x 10 units
Price on 29 July 2009: 2720 x $60 x 10 units
Net gain

$1 500 000
$1 632 000

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$132 000
$43 000

1513

1 July 2009
Dr
Cr

Futures receivable
Futures payable

1 500 000
1 500 000

(The futures receivable will not change and it represents the amount that would be received
when the contract matures. The futures payable represents the amount that would currently
be required to acquire 10 SPI futures units.)
Dr
Cr

Deposit on SPI futures


Cash at bank

100 000
100 000

(To record the deposit with the futures broker.)


After the initial recognition of the futures contract and the related deposit, the movements in
the value of the futures, and the share portfolio can be accounted for on the basis of
movements in net market values. The entries could be:
29 July 2009
Dr
Cr

Share portfolio
Income from increase in value of share portfolio

175 000
175 000

(To mark to market the value of the organisations share portfolio, and to treat the upward
movement as revenue.)
Dr
Cr

Loss on futures contract


Deposit held by broker

132 000
132 000

(This entry assumes that the losses are credited to the initial deposit held by the futures
broker. This entry would represent an aggregated entry as in practice the adjustments to the
deposit account may be made daily. Where there have been losses the investor would
probably have been required to make further payments to the broker to cover the losses
rather than just increasing the Futures payable account. We will assume in this question that a
further amount of $132 000 had been paid to the broker to cover the losses on the future
contract and to ensure that the broker still has $100 000 on hand to cover any future losses
that may arise).
Dr
Cr

Deposit held by broker


Cash at bank

132 000
132 000

(This is an aggregated entry which would cover the losses incurred on the futures contract up
to 29 July 2009.)
If Busta Ltd decides to sell it shares and close out its futures contract on 29 July 2009, the
accounting entries would be as shown below:
29 July 2009
Dr
Cr

Cash
Share portfolio

Dr
Cr

Cash at bank
Deposit held by broker

1 725 000
1 725 000
100 000

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100 000
1514

(This amount represents the total of the original deposit paid to the broker less the
accumulated losses of the SPI future since the date of entering the contract.)
Dr
Cr

Futures payable
Futures receivable

1 500 000
1 500 000

(To eliminate the futures receivable and the futures payable.)


15.25 Mamb Ltd is able to borrow money at either a fixed rate of 10 per cent, or at the 90 day
Bank Bill Rate plus 0.5 per cent (which fluctuates, but is presently 8 per cent). Bong Ltd can
borrow funds at either a fixed rate of 13 per cent, or at a the 90 Bank Bill Rate (BBR) plus
2.0 per cent.
Mamb Ltd borrows $1 000 000 in funds at a fixed rate of interest of 10 per cent, whereas
Bong Ltd borrows $1 000 000 for four years at the floating Bank Bill Rate plus 2.0 per cent.
Even though Mamb Ltd has an interest rate advantage in both the variable and fixed interest
rate markets, a swap rate can be agreed upon such that both Mamb Ltd and Bong Ltd can
benefit. One answer (and there can be a number of answers here) would be for Mamb Ltd to
make floating rate payments to Bong Ltd at the Bank Bill Rate plus 1.5 per cent, and Bong
Ltd to make fixed rate payments to Mamb Ltd at 12 per cent. The net interest payments of
both, after the agreement would be:
Mamb Ltd
Pays 10% to primary lender
Pays BBR + 1.5% to Bong Ltd
Receives 12% from Bong Ltd
Net interest cost = BBR 0.5%

Bong Ltd
Pays BBR + 2.0% to primary lender
Pays 12% to Mamb Ltd
Receives BBR + 1.5% from Mamb Ltd
Net interest cost = 12.5%

After the above interest rate swap, both organisations have their preferred type of borrowing
(that is, either fixed or variable) and both have made a net saving on the rates that were
available in the marketplace on their preferred means of borrowing.
15.26 AASB 132 requires compound equity instruments to be disclosed as part equity and part
liability. In considering how to measure the liability and equity components of the convertible
bonds we can determine the present value of the cash flows at the markets required rate of
return of 6 per cent. This amount would represent the liability component of the convertible
bonds. The difference between the liability component and the total issue price of the bonds
would represent the equity component.
We can identify the present value of the 3 year bonds and then allocate the difference between
the present value of these bonds and the issue price of $5 000 000 to the equity component.

Present value of bonds at the market rate of debt


Present value of principal discounted a 6 per cent:
$5 000 000 x 0.8396 =

$4 198 000

Present value of interest stream discounted at 6 per cent:


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$200 000 x 2.6730 =

$ 534 600

Total present value


Equity component
Total face value of convertible bonds
(a)

$4 732 600
$ 267 400
$5 000 000

The accounting entries could therefore be:


1 July 2009
Dr
Cr
Cr

Cash at bank
Convertible bonds liability
Option to convert bonds liability equity

5 000 000
4 732 600
267 400

(To record the issue of the convertible bonds and the recognition of the liability and
equity components.)
(b)

30 June 2010
Dr
Cr
Cr

Interest expense
Cash
Convertible bonds liability

283 956
200 000
83 956

(To recognise the interest expense, where the expense equals the present value of the
opening liability multiplied by the market rate of interestsee table below.)
The stream of interest expenses across the 3 years can be summarised as in the table
below, where interest expense for a given year is calculated by multiplying the present
value of the liability at the beginning of the period by the market rate of interest, this
being 6 per cent.
Date
1 July 2009
30 June 2010
30 June 2011
30 June 2012

Payment

Interest expense

200 000
200 000
200 000

283 956
288 993
294 333

Bond liability
4 732 600
4 816 556
4 905 549
4 999 882*

* $118 rounding error due to using tables rounded to 4 decimal places.


(c)

If the holders of the options elected to convert the options to ordinary shares on
1 July 2010, the entries would be:
Dr
Dr
Cr

Convertible bonds liability


Option to convert bonds liability equity
Share capital

4 816 556
267 400
5 083 956

(To recognise the conversion of the bonds into shares of Woodie Ltd.)
15.27 (a)

This is obviously a very strong opinion that is being given by Tweedie. Often, the use
of strong language is used to support an argument that is lacking in substance and
needs to be bolstered. The comment in relation to our accounting treatment being
deplorable focuses on our treatment of intangibles. There are counter arguments that
the IASB approach is unsound as it requires the write-off or non-recognition of many
intangible assets that have very real value. For example, in Chapter 8, which addresses
intangibles, we saw headlines like Big Flaws in Accounting Changes when making
reference to the new accounting requirements for intangibles. Further, quotes
reproduced in Chapter 8 from Colin Parker, a leading expert in the analysis of

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financial accounting standards, described the international accounting standards on


intangibles as seriously flawed, archly conservative, and not in the national
interest.
(b)

(c)

We can never be sure of the real motivations for corporate calls for change.
Possibilities would include:
(i)

the corporate managers believe that the accounting standards provide


information which is not as useful as it might otherwise be if we followed
different accounting requirements;

(ii)

they might believe that the change is too drastic and that a phased-in approach
would be more appropriate so as to enable investors and other interested
readers time to understand the changed requirements;

(iii)

their calls may be based on self-interest. Perhaps they have bonus schemes
which provide management with a percentage of profits. A reduction in profits
might lead to a reduction in their bonuses.

This is a very simplistic argument. It is based on the view that international investors
would not have the ability to reconcile the accounting results of an entity based on the
former Australian Accounting Standards with what they would be if the results were
generated from the application of international accounting standards. If the investment
returns were likely to be sufficient enough then it is very hard to believe that many
large institutional investors wont make the effort.

15.28 The broad reason why management would have concern about the changes would be that
they believe the various users of financial statements will react, possibly negatively, to the
changes made to the financial statements, relative to how the financial statements would have
appeared if the former Australian Accounting Standards had been used. For example, there is
a general view that it is better to show less debt than more debt. If the new standard requires
certain financial instruments to be classified as debt, rather than equity, then this may provide
the appearance that the entity is riskier than it might otherwise be. Whether the market
mechanistically reacts to changes in accounting numbers brought about by changed
accounting rules, however, is debatable.
In Chapter 3 we spoke at length about how organisations might have many agreements in
place that rely upon accounting numbers (debt governments that rely upon certain gearing
ratios and levels of profitability). To the extent that these agreements are not renegotiated
then a change in accounting rules could have real cash flow impacts for an organisation.
It could be anticipated that corporate managers would also be reluctant to embrace a whole
new set of accounting standards because of the very real costs this will impose in terms of
required changes to information collection and accounting systems, and the costs involved in
educating staff about the new accounting requirements. Of course, if the benefits of changing
accounting systems (for example, increased capital inflows) exceed the associated costs then
the opposition might not be so great. However there is little evidence to suggest that
Australias changed accounting system will suddenly prompt additional capital inflows.
15.29

(a)

The bonds can potentially be classified as at fair value through profit and loss because
they can be designated as such. The carrying amount should be $52 500 and the
change in fair value should be recognised in profit and loss.

(b)

The bonds may be classified as held to maturity if the entity intends to hold them to
maturity. They have a maturity date and there is no other information to suggest that
Safe Boards Ltd is precluded from using this category. The bonds should be recorded

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at amortised cost but there is no amortisation because they were issued at par. Change
in fair value is not recognised.
(c)

The bonds may not be classified as loans and receivables. Financial assets may be
classified as loans and receivables if they are non-derivative financial assets with fixed
or determinable payments but are not quoted in an active market (AASB 139,
paragraph 9). The bonds may not be classified as loans and receivables because they
are quoted in an active market.

(d)

The bonds may be classified as available for sale. The carrying amount should be
$525 000 and the change in fair value is recognised directly in equity.

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15.30

(a) Convertible note issue


Dr
Cash
Cr
Convertible notes
Cr
Conversion option

$500 000
$469 615
$30 385

Workings
Cash outflows are identified as:
Principal $500 000 at end of year 4 ($100 x 500 notes)
Interest $500 000 x 10% = $50 000 p.a.
To determine the amount to be allocated to the liability component, the fair value of a
similar note that does not have the conversion option is measured:

a
b

$500 000 x 0.6355a


317 750
b
$50 000 x 3.0373
151 865
Fair value of similar liability
469 615
Discount factor of $1 in four years, given interest rate of 12%.
Discount factor of $1 per year for four years, given interest rate of 12%.
Fair value of convertible notesc
Amount allocated to liability component
Residual allocated to equity component

$500 000
469 615
30 385

Fair value of the convertible note at the time of issue is the issue price, that is, the
gross proceeds of the issue.
c

(b)
Assets increased by
Liabilities increased by
Equity increased by

$500 000
$469 615
$30 385

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