FINANCIAL INSTRUMENTS

1. FINANCIAL INSTRUMENTS Recognition and Measurement FRS 139

2. Introduction

3. Introduction FRS 139 Financial Instruments: Recognition and Measurement establishes principles for recognising and measuring financial instruments.

4. Introduction • Common examples of Financial Instruments are: cash, demand & time deposits, commercial paper, accounts receivable and payable, debt and equity securities, asset backed securities such as collateralised mortgage obligations, repurchase agreements, & securitised packages of receivables & derivatives, including options, rights, warrants, futures contracts, forward contracts and swaps.

5. Scope

6. Scope • FRS 139 applies to all types of financial instruments except: • Interests in subsidiaries, associates and joint ventures where FRS 127, 128 or 131 apply; • Employers’ rights and obligations under employee benefit plans where FRS 119 applies; • Contracts for contingent consideration in a business combination; • Contracts requiring payment based on climatic, geological or other physical variable, except derivatives embedded in such contracts are subject to FRS 139; • Rights and obligations under insurance contracts; and • Financial Instruments that meet the definition of own equity under FRS 132.

7. Scope • FRS 139 applicable in limited respect to: • Leases; • Lease receivables with respect to the derecognition and impairment; • Lease payables with respect to derecognition provisions; and • Derivatives embedded in leases.

8. Scope • Financial guarantees; • Financial guarantees are not financial instruments. They could amount to insurance contracts where the issuer bears significant risks and is required to reimburse the holder of a debt instrument for loss because a specified debtor fails to pay the holder. • Financial guarantees that provide for payments to be made in response to changes in a specified variable (price, rate or index) are considered derivatives and within the scope of FRS 139;

9. Scope • Financial guarantees; • To be recognised at fair value and subsequently at the higher of: • Amount determined under FRS 137; and • The amounts initially recognised under FRS 139 minus amounts amortised as revenues

10. Scope • Loan Commitments • Not within the scope of FRS 139 if they cannot be settled net in cash or other financial instruments. • If the loan commitments are designated as financial liabilities at fair value through profit or loss, then the loan commitments come within FRS 139.

11. Scope • Contracts to buy and sell non-financial Items. • Contracts to buy non-financial items do not come under the purview of FRS 139 unless they can be settled net in cash or another financial assets. • Net settlement could constitute: • The terms of the contract permit either counterparty to settle net; • There is past practice of net settling for similar contract; • There is past practice, for similar contracts, of taking delivery of the underlying; or • The non financial item is readily convertible to cash.

12. Explanation

13. Explanation • FRS 132 covers the definitions of financial instruments, financial asset, financial liability and equity instrument. • FRS 139 also covers other items such as derivatives and hedging.

14. Explanation - Derivatives • Is a financial instrument arising from a contract to buy or sell or settle in cash or in a primary instrument. • Usually has a notional amount such as a specified amount of currency, number of shares, weight or volume specified in the contract.

15. Explanation - Derivatives • FRS 139 considers an item as a derivative when:- • Whose value changes in response to the change in an underlying variable such as interest rate, commodity or security price or index; • That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and • It is settled at a future date.

16. Explanation - Derivatives • Forward Contracts • Are contracts to buy or sell specified quantity of financial instruments, commodity or foreign currency at a specified rate determined at the outset but settlement or delivery is at a later date. • Settlement can be by net cash or by delivery of the items specified.

17. Explanation - Derivatives • Forward Contracts • Eg 1. LMN whose functional currency is RM, sells products in England denominated in £. LMN enters into a contract with Maybank to convert £ into RM at a fixed rate of 6.5. • This is a derivative as: • There is an underlying variable which is the foreign exchange rate; • No initial net investment (or an initial investment that is smaller than would be required for contracts that would respond in similar manner to changes in market factors and future settlement.

18. Explanation - Derivatives • Forward Contracts • Eg 2. Same facts with eg.1, and the contract requires LMN to remit £ based on its sales volume in England in exchange for RM at a fixed exchange rate of 6.5 • This is a derivative as: • There are 2 underlying variables, foreign exchange rate and volume of sales. • No initial net investment (or an initial investment that is smaller than would be required for contracts that would respond in similar manner to changes in market factors and future settlement).

19. Explanation - Derivatives • Interest Rate Swaps and Forward Rate Agreements • These are contracts to exchange cash flows based on notional amount and fixed and floating rates.

20. Explanation - Derivatives • Interest Rate Swaps and Forward Rate Agreements • Eg.3. XYZ issues a 10 year loan stock, with fixed interest rate of 5% to ABC. AT the same time ABC makes a 10 year variable rate loan for the same amount to XYZ. There is no transfer of principal at the inception of the 2 loans and both entities have netting agreement.

21. Explanation - Derivatives • Interest Rate Swaps and Forward Rate Agreements • Eg.3. (cont). In this case, it is a derivatives as: • There is an underlying variable; • No initial net investment (or an initial investment that is smaller than would be required for contracts that would respond in similar manner to changes in market factors and future settlement); • They have the same counterparty; and • Relate to the same risk.

22. Explanation - Derivatives • Futures • Futures are similar to forward except that these contracts are generic exchange traded. • Forwards, on the other hand are individually tailored. • Futures are generally settled by offsetting and not by delivery of underlying item or cash.

23. Explanation - Derivatives • Options • Options give the holder the right to buy (call option) a specified quantity of financial instrument, commodity or foreign currency at a specified price and time. • The buyer of the option pays the seller (writer) a fee (premium). • Options can be individually written or exchange traded.

24. Explanation - Derivatives • Caps & Floors • Caps and Floors are interest rate options. The holder of the cap will be compensated if interest rates rise above the predetermined rate (strike rate). • Similarly, an interest rate floor will compensate the holder if the interest rate drops below the predetermined rate.

25. Explanation – EmbeddedDerivatives • Contracts that does not fall within the financial instruments but may have financial instruments embedded in them, or hybrid or combined instruments. • The effect of this type of hybrid instrument is that the embedded derivatives causes the cash flow to be modified as if or similar to the stand alone derivatives, eg change in interest rate, commodity price or foreign exchange rate.

26. Explanation – EmbeddedDerivatives • Embedded Derivatives (ED) is to be separated from the host contract and accounted for as a derivative if: • The risk and the economic characteristics of the ED are not closely related to the host contract; • A separate instrument with the same term as the ED would meet the definition of derivatives; and • The host and ED together are not measured at fair value with changes in fair value recognised in the income statement.

27. Explanation – EmbeddedDerivatives • If the ED is separated, the host contract is accounted for, under appropriate reporting standards; • Where FRS 139 requires the separation but the entity is unable to measure separately, either at initial or at subsequent reporting dates, the combined contracts is to be treated as a financial asset of financial liability held for trading. • Eg. ED that can be separated, conversion right to equity in convertible debts.

28. Explanation – Hedging • A relationship between hedging instrument and the hedged item. A derivative can be a hedging instrument. 3 types of hedging relationship: • Fair value hedge; • Cash flow hedge; and • Hedge of a net investment in foreign operation (FRS 121)

29. Classification of Financial Instruments

30. Classification of Financial Instruments • FRS 139 classifies financial instruments into 4 categories, namely:- • Financial asset or financial liability at fair value through profit or loss; • Held to maturity investments; • Loans and receivables; and • Available for sale financial asset.

31. Classification of Financial Instruments • Financial Asset of Financial Liability at Fair Value Through Profit or Loss • Held for trading. All instruments (except derivatives designated for hedging) acquired or held for the purpose of selling in the short term or which are part of a portfolio which have a recent pattern of short term profit taking; or • Designated on initial recognition as one to be measured at fair value with fair value changes taken to the income statement. Equity instruments that do not have quoted market price and those fair value cannot be reliably measured are excluded from this sub category.

32. Classification of Financial Instruments • Held To Maturity Investment • Refers to non-derivative financial assets with fixed or determinable payments that entity intends to and has an ability to hold to maturity. • Do not include loans and receivables, those available for sale or those designated on initial recognition as at fair value through profit or loss.

33. Classification of Financial Instruments • Loans and Receivables • Non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. • They exclude financial assets designated at initial recognition as available for sale or designated as assets at fair value through profit and loss or held for trading.

34. Classification of Financial Instruments • Available for Sale • Non-derivative financial assets designated at initial recognition as available for sale and are not classified as loans and receivables, held to maturity or financial assets at fair value through profit or loss.

35. Recognition

36. Recognition • FRS 139 requires recognition of financial asset or financial liability when an entity becomes a party to the contractual provisions of the instrument.

37. Recognition • Trade Date is the date the entity commits itself to purchase (or sell) an asset. • Settlement date is the date when the asset is delivered to or by the entity.

38. Recognition • FRS 139 requires all financial assets and financial liabilities to be recognised on the balance sheet date. • Derivatives are also to be recognised, even if initially derivatives have zero cost.

39. Recognition • Eg. 4. On 24 December year 2, ABC entered into a contract to buy a financial asset for RM30,000 which was its fair value on that date. Transaction costs are immaterial. • On 31 December year 2, which is the financial year end for ABC, the fair value of the financial asset was RM31,000. The fair value of the instrument on settlement date, which was 10 January year 3, was RM31,800.

40. Recognition • Eg. 4. (Answer) Trade Date Accounting • If held to maturity & carried at amortised cost • DRCR • 24 Dec Yr 2 • Financial Asset 30,000 • Financial Liability 30,000 • 31 Dec Yr 2 • Financial Asset 0 • Financial Liability 0

41. Recognition • Eg. 4. (Answer) Trade Date Accounting • If available for-sale-asset • DRCR • 24 Dec Yr 2 • Financial Asset 30,000 • Financial Liability 30,000 • 31 Dec Yr 2 • Financial Asset 1,000 • Equity (fair value adjustment) 1,000 • 10 Jan Yr 3 • Financial Asset 800 • Equity (fair value adjustment) 800

42. Recognition • Eg. 4. (Answer) Trade Date Accounting • If Classified as at fair value through profit/loss • DRCR • 24 Dec Yr 2 • Financial Asset 30,000 • Financial Liability 30,000 • 31 Dec Yr 2 • Financial Asset 1,000 • Income Statement (fair value adjustment) 1,000 • 10 Jan Yr 3 • Financial Asset 800 • Income Statement (fair value adjustment) 800

43. Recognition • Eg. 4. (Answer) Settlement Date Accounting • If held-to-maturity carried at amortised cost • DRCR • 10 Jan Yr 3 • Financial Asset 30,000 • Cash 30,000

44. Recognition • Eg. 4. (Answer) Settlement Date Accounting • If it is available-for-sale-asset • DRCR • 31 Dec Yr 2 • Receivable 1,000 • Equity (fair value adjustment) 1,000 • 10 Jan Yr 3 • Financial Asset 31,800 • Equity (fair value adjustment) 800 • Cash 30,000 • Receivable 1,000

45. Recognition • Eg. 4. (Answer) Settlement Date Accounting • If classified as at fair value through profit/loss • DRCR • 31 Dec Yr 2 • Receivable 1,000 • Income Statement 1,000 • 10 Jan Yr 3 • Financial Asset 31,800 • Income Statement (fair value adjustment) 800 • Cash 30,000 • Receivable 1,000

46. Measurement

47. Measurement • Initially financial assets and liabilities are measured at fair value. • For those that are not measured at fair value through profit or loss, the transaction costs directly attributable to the acquisition or issue are included as part of the initial cost (fair value).

48. Measurement • Fair Value is the “amount for which an asset could be exchanged, or a liability settled, between knowlegeable, willing parties in an arm’s length transaction”.

49. Measurement • Appendix A to FRS 139 provides an order to be used: • Quoted market price in an active market should be used if one exist; • If the market for the financial instruments is not active, then a valuation technique that incorporates market inputs, recent arm’s length transaction, current fair value of similar instrument, discounted cash flow analysis and option pricing models to be used (methods should be economically accepted); • For equity that does not have an active market and the value cannot be reliably measured, the equity is measured at cost less impairment.

50. Measurement • Transaction Costs • Such as fees and commission, are included in the initial measurement of financial assets and financial liabilities except for instruments that are accounted for at fair value through profit and loss. • For financial asset – costs are directly attributable to the acquisition of the asset are to be added to the amount initially recognised. • For financial liabilities – costs directly related to the issue of debt are deducted from the amount of debt recognised initially.