Financial Instruments

1. Chapter 7 Financial Instruments

2. Objectives • Define a financial instrument • Outline and explain the concepts of financial assets, financial liabilities and derivatives • Distinguish between equity instruments and financial liabilities • Disclosure requirements and scope of IFRS 7 & MFRS 139

3. Objectives • Recognition and measurement criteria for financial instruments • Hedge accounting • Overview the requirements of IFRS 9 • Describe expected future developments

4. MFRS 132 sets out the definitions of financial assets, liabilities and equity instruments IFRS 7 contains many of the disclosure requirements of MFRS 132 as well as new requirements IAS 39 (MFRS 139) originally based on FASB standard. Includes procedures for the recognition and measurement of financial instruments. IFRS 9 formulated to replace IAS 39 (MFRS 139) (as yet lacks endorsement by the European parliament) Introduction to IAS 32, IFRS 7, IAS 39 & IFRS 9

5. 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 What is a Financial Instrument?

6. Financial assets: Defined IAS 32 para 11 Viewed from holder’s perspective Include: cash, shares, receivables and options Para 11 (MFRS 132) Afinancial asset is 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 entity’s 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 entity’s own equity instruments; or (ii) a derivative that will or may be settle d other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include puttable financial instruments classified as equity instruments in accordance with paragraphs 16A and 16B , instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D , or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments. Financial Assets

7. Financial Liabilities • Financial liabilities: • Defined IAS 32 para 11 • Viewed from issuer’s perspective • Include: payables, unfavourable options Para 11 (MFRS 132) A financial liability is any liability that is: (a) 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 (b) a contract that will or may be settled in the entity’s 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 entity’s 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 entity’s own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Also, for these purposes the entity’s own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D , or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments. As an exception, an instrument that meets the definition of a financial liability is classified as an equity instrument if it has all the features and meets the conditions in paragraphs 16A and 16B or paragraphs 16C and 16D .

8. Equity • An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

9. Puttable instrument • A puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder

10. Common Financial Instruments Holder of FI Issuer of FI

11. 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 Derivatives

12. 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

13. 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 Refer to Figure 7.3 for application Part B – The instrument will or may settled in the issuer’s own equity instruments Distinguishing Financial Liabilities From Equity Instruments – Substance Over Form Test

14. 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 Compound Financial Instruments

17. Interest, Dividends, Gains & Losses

18. The purpose of disclosures prescribed by IFRS 7 is toassist users in assessing the risk related to financial instruments Market risk Credit risk Liquidity risk Refer to Tables 7.5 – 7.7 for examples Disclosures

19. 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

24. Defined in IAS 39 An instrument whose value is derived from underlying item: share price, interest rate, etc. Derivatives must meet the following characteristics: It’s value must change in response to the change in a specified variable Requires no/minimal net investment Settled at some time in the future Include futures, forward, swap and option contracts May be standalone or embedded in a compound (‘hybrid’) instrument Derivatives and Embedded Derivatives

25. IAS 39 (MFRS 139)recognises four categories of financial instruments as follows: A financial asset or liability at fair value through profit or loss (FVTPL) Held-to-maturity investments (HTM) Loans & receivables Available-for-sale financial assets (AFS) The Four Categories of Financial Instruments

26. The Four Categories of Financial Instruments

27. The Four Categories of Financial Instruments

28. A financial instrument is recognised when the entity becomes a party to the contractual provisions of the instrument IAS 39 (MFRS 139) measurement rules address: Initial measurement Subsequent measurement Fair value measurement considerations Reclassifications Gain and losses Impairment/uncollectability Recognition Criteria

29. 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 Measurement

30. Subsequent Measurement • Depends on whether the item is an asset or liability and on which of the categories applies • Assets: • IAS 39 para 45 • Refer Illustrative Example 7.1 • Liabilities: • IAS 39 para 47 • Refer Illustrative Example 7.2

35. Impairment and Uncollectability

41. 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

42. 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 - Definitions

43. Hedge Accounting - Conditions • Five conditions must be met in order for hedge accounting to be applied: • Must be formal designation and documentation of the hedge at inception • The hedge must be expected to be highly effective (80% - 125%) • For cash flow hedges the transactions must be highly probable • The effectiveness of the hedge must be able to be reliably measured • The hedge must be assessed on an ongoing basis for effectiveness

44. 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 Hedge Accounting – Types of Hedges

45. Fair value hedge

47. Cash Flow Hedge