Lecturer 5

FINANCIAL INSTRUMENTS
PICKER, ET AL. (2012). CHAPTER 7
IAS39.PDF
IFRS 7
IFRS 9
 Objectives

1. Define a financial instrument

2. Outline and explain the concepts of financial assets,
financial liabilities and derivatives
3. Distinguish between equity instruments and financial
liabilities
4. Disclosure requirements and scope of IFRS 7 & IAS 39
5. Recognition and measurement criteria for financial
instruments
6. Hedge accounting
7. Overview the requirements of IFRS 9
8. Describe expected future developments
 Introduction to IAS 32, IFRS 7,
IAS 39 & IFRS 9

 IAS 32 sets out the definitions of financial assets,

liabilities and equity instruments
 IFRS 7 contains many of the disclosure
requirements of IAS 32 as well as new
requirements
 IAS 39 originally based on FASB standard.
Includes procedures for the recognition and
measurement of financial instruments.
 IFRS 9 formulated to replace IAS 39 (as yet lacks
endorsement by the European parliament)
 What is a Financial Instrument?

 Financial Instrument:
“ any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity”

 Primary instruments:
 Cash, receivables, investments, payables

 Secondary (derivative) instruments:

 Value is derived from underlying item: share price,
interest rate, etc.
 Financial options, forward exchange contracts
Financial Assets and Financial Liabilities

 Financial assets:
 Defined IAS 32 para 11
 Viewed from holder‟s perspective
 Include: cash, shares, receivables and options

 Financial liabilities:
 Defined IAS 32 para 11
 Viewed from issuer‟s perspective
 Include: payables, unfavourable options
 Common Financial Instruments

Summary of common Financial instruments

Financial Assets Financial Liabilities Equity Instruments
Cash Bank overdraft Ordinary shares
Accounts receivable Accounts Payable Certain preference shares
Notes receivable Notes payable
Loans receivable Loans payable
Derivatives with Derivatives with potentially
potentially favourable unfavourable exchange
exchange conditions conditions
Certain preference shares
 Demystifying Derivatives

 Derivatives transfer financial risks of the underlying

primary financial instrument

 One party acquires a right to exchange a financial asset

or liability with another party under potentially
favourable conditions. The other party takes on the
right to exchange under potentially unfavourable
conditions.

 Parties to derivatives are taking bets on what will

happen to it in the future
 Distinguishing Financial Liabilities From Equity
Instruments

 Debt/equity distinctions are important – affects

gearing and solvency ratios, debt covenants,
treatment of payments as either interest or
dividends & capital adequacy requirements

 A „substance over form‟ test in IAS 32 aims to limit

attraction to misclassify many as equity
instruments
Distinguishing Financial Liabilities From Equity Instruments
– Substance Over Form Test

 Classification addressed in IAS 32 para 15 – 16

 Equity instruments need to meet two conditions (A & B)

 Part A - An equity instrument must include no contractual

obligation to:
 Deliver financial assets to another entity
 Exchange assets/liabilities unfavourable to the issuer
 Ordinary Shares
 Non-cumulative, non-redemable preference shares
 Cumulative, redeemable preference shares.
 See figure 7.3, pp. 222-224

 Part B – The instrument will or may settled in the issuer‟s own

equity instruments
 Compound Financial Instruments

 Compound financial instruments contain both a

liability and an equity component

 IAS 32 para 28-29 & 31-32 provide key

information

 IAS 32 prescribes that the financial liability must

be calculated first with the equity component
by definition being the residual
 Refer Figure 7.4 A convertible note, allocating the
components between liability and equity.
 Interest, Dividends, Gains & Losses

Classification of revenues, expenses and equity distributions

Statement of financial Statement of profit or loss and Statement of Changes
position classification other comprehensive income in equity
classification
Equity instrument Dividends distributed
Financial liability Interest expense
Financial asset Interest income, dividend
income
 Disclosures

 The purpose of disclosures prescribed by IFRS 7 is

to assist users in assessing the risk related to
financial instruments
 Market risk
 Credit risk
 Liquidity risk

 Refer to Tables 7.5 – 7.7 Significance of financial

instruments for disclosures purposes
 Disclosures

Financial risks pertaining to financial instruments

Type of Risk Description
Market Risk Currency risk – the risk that value of FI will fluctuate due to
changes in foreign exchange rate.
Interest rate risk – the risk that the value of FI will fluctuate
because of changes in market interest rates.
Other price risk - the risk that the value of FI will fluctuate as a
result of changes in market prices.
Credit risk The risk that one party to FI will fail to discharge an obligation
and cause other party to incur a financial loss.
Liquidity risk The risk that an entity will encounter difficulty in meeting
obligations associated with financial liabilities. This is also
known as funding risk .
 Disclosure

 Significance of financial instruments for financial

position and performance.
o Categories of financial assets and financial liabilities (IAS 39,
para. 8). E.g. financial assets at FV through P or L, held-to-
maturity instruments.
o Financial assets or financial liabilities at fair value through
profit or loss (IAS 39, para. 9, 10, and 11)
o Reclassification (IAS 39, para. 12) – Disclosure required for
the amount and the reason for reclassification.
o Derecognition (IAS 39, pa. 13) – Specified disclosure are
required where an entity has transferred financial assets..
 Significance of financial instruments for financial position and performance.

 Collateral (IAS 39, para. 14 and 15) – To disclose

collateral given and collateral received.
 Allowance for credit losses (IAS 39, para. 16) – When
financial assets are impaired by credit losses.
 Compound financial instruments with multiple
embedded derivatives (IAS 39, para. 17) Disclosure is
required for existence of such.
 Defaults and breaches (IAS 39, para. 18 and 19) For
loans payable, disclosure is required for any defaults
during the period.
 Disclosure

 Statement of profit or loss and other comprehensive

income.
o Items of income, expense, gains or losses (para. 20)
 Significance of financial instruments for other
disclosures.
o Accounting policies (para. 21)
o Edge Accounting (para. 22, 23 and 24).
o Fair value (para. 25-30)
 Scope of IAS 39

 Stated objective to establish principles. Arguably it

establishes rules rather than principles

 A very complex standard that applies to all entities and

to all types of financial instruments, with ten exceptions
(para 2)

 Applies to contracts equally proportionately unperformed

 Derivatives and Embedded Derivatives

 Defined in IAS 39
 An instrument whose value is derived from underlying item: share price,
interest rate, etc.

 Derivatives must meet the following characteristics:

1. It‟s value must change in response to the change in a specified variable
2. Requires no/minimal net investment
3. Settled at some time in the future

 Include futures, forward, swap and option contracts

 May be standalone or embedded in a compound („hybrid‟)

instrument
The Four Categories of Financial Instruments

 IAS 39 recognises four categories of financial

instruments as follows:

1. A financial asset or liability at fair value through profit or loss

(FVTPL)
2. Held-to-maturity investments (HTM)
3. Loans & receivables
4. Available-for-sale financial assets (AFS)
The four categories of Financial Instruments
Category Characteristics
Financial Meets one of two conditions:
asset or  Held for trading; or
liability at  Designated upon acquisition as
FVTPL being held at FV with changes
in FV being recorded through
P&L
HTM  Non derivative financial assets
investments with fixed or determinable
payments and fixed maturity
 The entity has the positive
intention and ability to hold
these assets until maturity
Examples
Share portfolio held for short
term gains, forward
exchange contract, interest
rate swap, call option (all
derivatives other than
hedges)
Commercial bill investments,
govt. bonds, fixed term
debentures, convertible
notes (which convert at a
fixed date in the future)
 The Four Categories of Financial Instruments

Category Characteristics Examples

Loans & Non-derivative financial assets with Accounts receivable, loans

receivables fixed or determinable payments to other entities
that are not quoted in an active
market

AFS financial Non-derivative financial assets that Ordinary share

assets are designed as available for sale investments, other
and do not fall into any of the convertible notes
above categories
 Recognition Criteria

 A financial instrument is recognised when the entity

becomes a party to the contractual provisions of the
instrument

 IAS 39 measurement rules address:

1. Initial measurement
2. Subsequent measurement
3. Fair value measurement considerations
4. Reclassifications
5. Gain and losses
6. Impairment/uncollectability
 Measurement

 Initial recognition = fair value + transaction costs

 Transaction costs include:

 Fees and commissions
 Levies by regulatory agencies and securities exchanges
 taxes and duties

 Transaction costs do not include:

 Debt premiums or discounts
 Financing costs
 Internal administrative costs
 Subsequent Measurement

 Depends on whether the item is an asset or liability

and on which of the categories applies

 Assets:
 IAS 39 para 45

 Liabilities:
 IAS 39 para 47
 Impairment and Uncollectability
Category
FVTPL
(At fair value through P/L)
HTM investments
(Held-to-maturity
investments)
Loans & receivables
AFS financial assets
(Available-for-sale)
Impairment losses recognised as
follows…
N/A – impairment rules do not apply
Difference between the CA and the PV of
expected future cash flows discounted at
the assets original effective interest rate.
As above
Cumulative losses recognised directly in
equity must be removed and recognised in
P&L
 Hedge Accounting

 Hedge arrangements are entered into to protect an

entity from risk – e.g. currency or interest rate risk

 Hedge accounting generally results in a closer

matching of the statement of financial position effect
with the profit or loss effect

 Protects the statement of profit or loss and other

comprehensive income from volatility caused by fair
value changes over time
 Hedge Accounting - Definitions

Hedging instrument
 A hedging instrument is a financial asset or financial liability whose fair
value or cash flows are expected to offset changes in the fair value or
cash flows of a designated hedge item
 Eight essential criteria for an instrument to be classified as a hedging
instrument

Hedged item
 A hedged item is an asset, liability or anticipated transaction that:
 Exposes the entity to risk of changes in fair value or future cash flows
and
 Is designated as being hedged
 Hedge Accounting - Conditions

 Five conditions must be met in order for hedge

accounting to be applied:

1. Must be formal designation and documentation of the hedge at inception

2. The hedge must be expected to be highly effective (80% - 125%)
3. For cash flow hedges the transactions must be highly probable
4. The effectiveness of the hedge must be able to be reliably measured
5. The hedge must be assessed on an ongoing basis for effectiveness
 Hedge Accounting – Types of Hedges

Fair value hedge

 A hedge of the exposure to changes in the FV of an asset,
liability or commitment

Cash flow hedge

 A hedge of the exposure to the variability in cash flows of a
recognised asset or liability or forecast transaction
 Locks in future cash flows

Hedge of a net investment in a foreign operation

 Similar to a cash flow hedge
Cash Flow Hedge
 Expected Future Developments

 IASB intends to supersede IAS 39 with IFRS 9

 It is anticipated that hedging rules will be simplified and

that earlier recognition of impairment losses will be
permitted

 Should all bank assets be measured at fair value?