BMAN 21020:

Financial Reporting and Accountability

Semester 2
Lecture 8: Financial Instruments

huw.morgan@manchester.ac.uk
Office hours: Book via email or via SOHOL
 By the end of this lecture, you should be
able to…
 Understand how accounting standards have developed in this
area
 Define and describe financial instruments
 Define the scope of international accounting standards regarding
financial instruments (IAS 32, IAS 39 & IFRS 7)
 Identify and explain the main requirements of the international
standards for financial instruments
 Understand why there is a debate about these current
requirements and describe possible future changes to the
requirements
 Context: the history

1990 IASC issues exposure draft discussing fair value measurement for some financial instruments

1993 FRS 4 Capital Instruments issued by ASB in UK

1995 IAS 32 Financial Instruments: Disclosure and presentation
1999 IAS 39 Financial Instruments: Recognition and measurement
2005 After much debate, EU adopts a ‘carved out’ version of IAS 39 for use in the EU. One of the choices
regarding classification in the IASC version will not apply in the EU

2005 IFRS 7 Financial Instruments: Disclosure issued by IASB. IAS 32 amended to cover presentation
only
2008 IASB allows ‘fast-tracked’ amendments to IAS 39 to allow some more flexibility in reclassifying
financial instruments (response to credit crisis and US GAAP)

2009 Start of replacement of IAS 39: Phase 1 Classification and Measurement: IFRS 9 Financial
Instruments; Phase 2 Impairment methodology: Exposure Draft Amortised Cost and Impairment

2010 Phase 3 Hedge Accounting: Exposure Draft issued December 2010

2011 Phase 1: limited modifications to IFRS 9; Phase 2 supplementary document Financial Instruments:
Impairment issued
 Definitions

• A financial instrument is ‘any contract that gives rise to a financial asset of one enterprise and a
financial liability or an equity instrument of another enterprise’ (IAS 32 and IAS 39)
• A financial asset is any asset that is:
• cash, or a contractual right to receive cash or another financial asset from another
enterprise
• a contractual right to exchange financial instruments with another enterprise under
conditions that are potentially favourable
• an equity instrument of another enterprise
• A financial liability is any liability that is a contractual obligation:
• to deliver cash or another financial asset to another enterprise
• to exchange financial instruments with another enterprise under conditions that are
potentially unfavourable
• An equity instrument is a contract which evidences a residual interest in the assets of
an entity after deducting all of its liabilities
Practical application
of definitions Prepayment
for goods/
services

Which of these Debentures

Trade
receivables
are financial
instruments?
?
Which ones are
Ordinary
financial assets shares
Cash

or liabilities?
Preference
shares

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 Other types of financial instrument…
Other examples of financial instruments:
 derivatives such as financial options, futures, forwards, interest rate
swaps, currency swaps
DERIVATIVES: are financial instruments:
 whose value changes in response to the change in a specified
interest rate, security price, commodity price, foreign exchange rate,
index of prices or rates, a credit rating or credit index or similar
variable (underlying item)
 that require no initial net investment or little initial net investment
relative to other types of contracts that have a similar response to
changes in market conditions
 that are settled at a future date 6
 Example: MS p. 385, C&McK p.479
On 31 December 2012 a company acquires an option to
purchase 20,000 shares in ABC plc at 50p per share. The option
is exercisable on 31 March 2013. The cost of the option is £750.
The share price on ABC plc on 31 December 2012 is 48p.

Required: Explain whether the option meets the definition of a

derivative.

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 The international accounting standards

 IAS 32 Financial Instruments: Presentation

 IAS 39 Financial Instruments: Recognition and
Measurement
 IFRS 7 Financial lnstruments: Disclosures

[we are NOT covering IFRS 9]

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 Why is this area so complex?
 Applies not just to banks – most companies do something that brings them
into scope
 If financial instruments not reflected in financial statements, this undermines
true & fair view
 Risk exposure (even if not speculating!) needs to be reflected
But…problematic
 Sometimes hard to identify financial instruments
 How do you measure financial assets/liabilities?
 Historic cost – out of date if values change
 Fair value – more relevant, but is it reliable? Unrealised gains/losses?
 What happens to change in fair value year on year?
 Still changing – economic circumstances, sharper focus, user understanding 9
 IAS 32: Main issue: Debt vs equity presentation

Outflow of
Obligation Reliably
Liability: (past event)
economic
benefits
measurable

No obligation;
Residual
Equity Variable
returns
interest

If preference shares have a fixed non-discretionary dividend

and/or are redeemable and company cannot opt out of
redemption, this creates an obligation:
 Legal form = equity
 But substance (and IAS 32) = debt (dividends are finance costs!) 10
 Example (MS p387, C&McK p481)
How should a company classify the two items in issue in Dec 2015?

5m £1 4.5% bonds 2018 12 million ordinary shares of 25p

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 “Deep Issued at a 4% discount on 31 Mar-12:
Discounting” 2m 50p 3% bonds 2018, redeemable at par

Cash Flows Internal Rate of Return

Date £
2012 960
(Implicit Interest Rate)
2013 (30) • True cost of Finance:
2014 (30)
• PV of future outflows = Current Receipt
2015 (30)
2016 (30)
• 3.575% in this example!
2017 (30)
2018 (1,030)
Interest (220)
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 IAS 32: Compound instruments (convertible debt)

• Split presentation into both equity and liability elements

• Measure liability by deriving fair value of a similar liability
without conversion option
• Total fair value-liability fair value = residual equity fair value
• Fair value is the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable
willing parties in an arm’s length transaction.

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Compound Issued at par on 31 March 2012: 2m 50p 3%
Instrument convertible bonds 2018. Similar bonds
[MS p388] without conversion rights: valued at £960,000.

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 Compound 2m 50p 3% convertible bonds 2018 issued
Instrument at par on 31-3-12. Similar bonds without
[MS p388] conversion rights: required return: 3.575%.
If the required return on bond (without conversion rights) given instead of FV:
 Use this information to calculate the Present value of the Future cash outflows.
This will equal the current Fair value of the debt:

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 IAS 39: Recognition
 Based on key principles ….
 ….but application is complex!
 Recognise when become party to transaction
(sign on the line)
 Derecognise when lose control of:
 contractual rights (asset) or
 on cancellation/discharge/expiration of obligation
(liability)
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 IAS 39: Measurement
Initial Measurement at fair value [FV], plus transaction costs

Subsequent measurement:
Financial assets at fair value FV, with gains/losses in
through profit or loss [FVTPL] e.g. Income Statement
assets held for profit from short term fluctuations
Held-to-maturity [HTM] investments Amortised cost using effective
e.g. bond with fixed redemptive date interest method
Loans and receivables e.g. trade Amortised cost using effective
receivables, loans to others interest method
Available-for-sale [AFS] financial FV, with gains/losses in Other
assets e.g. invests. in shares/debts of other entities Comprehensive Income 17
 HFT vs AFS – both at …. so what’s the
fair value (FV)…… difference?
Buy shares worth £500. They increase in value to £502 after a year, and To £506
after 2 years. They are then sold for £510
Held For Trading [FVTPL] Available For Sale [FVTOCI]
Recognition: cost £500 £500
End of year 1: FV £502 £502
Gain £2 – through profit £2 – to AFS reserve
End of year 2: FV £506 £506
Gain £4 – through profit £4 – to AFS reserve
Disposal for £510 Cash £510 Cash £510
Derecognise asset £506 Derecognise asset £506
Further gain of £4 to profit Recycle gains from AFS reserve to
profit (£4+£2) = £6
Total gain of £10 in profit 18
 Amortised cost
• “Rolling up” transaction costs and differences between issue and
redemption value in an effective interest rate (which may be
different from the coupon (cash interest) rate
So need to start with initial proceeds after transaction costs
deducted
 Effective interest rate (yield to maturity) is internal rate of return of
instrument – the rate which exactly discounts the future cash flows
to the net carrying amount.
It’s the true rate of return on the instrument
 Need to “roll up” to amount that is repayable at the date of maturity
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 Ellie plc issued corporate bonds for £3m. The coupon
Amortised interest rate was 4% and issue costs were £100,000. The
cost bonds will be redeemed by the company in 4 years’ time for
£3.2m. The effective interest rate is 5.5%. Show how the
finance cost (interest) and carrying value of the loan is
shown in Ellie plc’s financial statements in years 1 and 2.

End of year Opening Finance cost Cash Redemption Closing

liability 5.5% interest liability
payment 4%
£m £m £m £m £m

1 2.900 0.160 -0.120 N/A 2.940

2 2.940 0.162 -0.120 N/A 2.981

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 Amortised cost: Eg2
(MS p. 395) Metston plc.

Metston plc issued £5m 50p 7% bonds on 1 Jan-09, at a 10%

discount (so only £2,250,000 is received) from the lenders, and
costs of issue amount to £120,000. Interest is to be paid
annually at the end of each year and the bonds are to be repaid
at a premium of 20% on 31 Dec. 2013. The effective interest
rate is 14.3%.
 At what amount will the bonds be measured on 1 Jan. 2009?
 Calculate the amortisation of the cost of the bond over the 5
years to 31 Dec-13.
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 IFRS 7: Disclosures

Extensive… Quantitative and qualitative:

So that users can understand significance of FIs, risks
involved and exposures:
 Information on market risk, liquidity risk, credit risk
 How these risks are managed (e.g. sensitivity analysis AND
qualitative disclosures)
 Need awareness only: – have a look at
 M&S or
 Easyjet for what they look like

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 Criticisms of the current international standards in this area

 Little understanding of the rules and what results from them

(preparers or users)
 Onerous burden on preparers, may dilute the key points
 Fair value – concept and detail
 Following the rules may threaten true and fair view for some
complex instruments
 Ongoing project for IASB

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 Reading and exercises
Reading
MS Chapter 8 (C&McK Chapter 8) Section 3: Advanced aspects
Elliott & Elliott 16th ed. Chapter 14
Further reading (available on Blackboard)
 Millar, T. (2010) Great expectations. Accountancy, August, pp66-67.
 Laux,C. and Leuz, C. (2009) The crisis of fair-value accounting: making
sense of the recent debate. Accounting, Organizations and Society 34
(7) pp.826-834
Exercises
Exercise from MS Chapter 8 (C&McK chapter 8) – Questions 8,9 & 10
Solutions to these will be available on Blackboard