Financial Instruments

Presentation - IAS 32
Recognition & Measurement – IAS 39
& IFRS 9
Disclosure – IFRS 7
 What we will cover this week
 Financial instruments
 What are they?
 How do we value them?
 How do we show them in financial
statements?

 Relevant standards:
 IAS 32, IAS 39, IFRS 7 and IFRS 9
Extra reading required
 Elliott and Elliott:
 Chapter 12
 The most controversial standards

 IAS 32, IAS 39 and IFRS 7 have proved the

most controversial of all the IASs for the
adoption.
 IAS 32 Financial Instruments: Presentation
 IAS 39 Financial Instruments: Recognition and
measurement
 IFRS 7 Replaces parts of IAS 32 on disclosure
 IFRS 9 Has replaced IAS 39. Effective from
accounting periods commenced from 1 Jan 2013
 Originally there was 1 standard but the
Recognition & Measurement aspects had to
be split out (into IAS 39) in an effort to get
agreement
 Why all these standards?

 Types of investments that companies make

are increasingly more involved
 Little guidance prior to IAS 32 and IAS 39
 Result:
 Many transactions were ‘off balance sheet’
 Standards have brought consistency to
accounting
 Definition – Financial Instrument

 “any contract that gives rise to both a

financial asset of one enterprise and a
financial liability or equity instrument of
another enterprise”
IAS 32 para 5

 The contract is the financial instrument

 NB: equity = share capital & reserves

 Definition – Financial Asset
An asset that is:
 Cash
 A contractual right to receive cash or other financial
asset e.g. a trade receivable
 A contractual right to exchange financial instruments
with another enterprise under potentially favourable
conditions
 An equity instrument of another enterprise

 ASSETS THAT HAVE A FINANCIAL VALUE ONLY

– HAVE NO TANGIBLE FORM.
WOULD NOT INCLUDE INVENTORY OR NON
CURRENT ASSETS
 Definition – Financial Liability
A liability that is a contractual obligation to:
 Deliver cash or other financial asset to another
enterprise e.g. trade payable; or
 Exchange financial instruments with another
enterprise under potentially unfavourable conditions
(Note how these mirror the asset definitions)

 LIABILITIES THAT HAVE A FINANCIAL VALUE

ONLY RATHER THAN REQUIRING DELIVERY OF
TANGIBLE ASSETS
e.g. NON CURRENT ASSETS OR VALUABLE
SERVICES
Definition – Equity instrument
 Equity instruments:
 Any contract that evidences a residual
interest in the net assets of an entity
e.g. SHARE CAPITAL
The following transaction gives rise to a
Financial Instrument because...
e.g.(1) A Company makes an issue of loan stock
The issue of loan stock creates a contractual
obligation. The contract is a financial instrument
because there is

Financial asset:
The lenders have the right to be repaid.

Financial Liability:
The Company is under an obligation to repay
the loan.
The following transaction gives rise to a
Financial Instrument because...
e.g.(2) A Company sells goods to a customer on
credit
The sale on credit creates a contractual
obligation. The contract is a financial instrument
because there is

Financial asset:
The Company now has a trade receivable.

Financial Liability:
The customer now has a trade payable.
The following transaction gives rise to a
Financial Instrument because...
e.g.(3) A Company buys goods from a supplier
on credit
The purchase on credit creates a contractual
obligation. The contract is a financial instrument
because there is a

Financial asset:
The supplier now has a trade receivable.

Financial Liability:
The Company now has a trade payable.
The following transaction gives rise to a
Financial Instrument because...
e.g.(4) A Company deposits money into a bank
account.
A bank deposit creates a contractual obligation.
The contract is a financial instrument because
there is:
Financial asset:
The company has the right to withdraw the
cash.
Financial Liability:
The bank is under an obligation to repay the
cash.
The following transaction gives rise to a
Financial Instrument because...
e.g.(5) A Company overdraws its bank account.

A bank overdraft creates a contractual

obligation. The contract is a financial instrument
because there is:
Financial asset:
The bank has a right to be repaid

Financial Liability:
The Company is under an obligation to repay
the overdraft.
The following transaction gives rise to a
Financial Instrument because...
e.g.(6) A Company issues ordinary shares.

Issuing shares creates a contract between the

Company and the shareholders. The contract is
a financial instrument because there is:

Financial asset:
The shareholders own the shares.

Equity instrument:
The Company has extra share capital.
The following transaction gives rise to a
Financial Instrument because...
e.g.(7) A Company buys ordinary shares.

Issuing shares creates a contract between the

Company and the shareholders. The contract is
a financial instrument because there is:

Financial asset:
The investing Company owns the shares

Equity instrument:
The issuing Company has extra share capital.
 QUIZ TIME
 Are the following financial assets or
financial liabilities?
 Prepayments for goods and services
e.g. insurance paid in advance
 Liability for corporation tax
 QUIZ TIME
 Are the following financial assets or financial liabilities?

 Prepayments for goods and services

e.g. insurance paid in advance

Neither, future economic benefit will be the receipt of

goods or services rather than a financial asset

 Liability for corporation tax

Neither, it is not a financial liability because the

obligation is statutory rather than contractual
FINANCIAL ASSETS AND LIABILITIES:
Recognition and initial measurement
Recognise the financial asset
OR financial liability when:
 The entity becomes a party to the
contractual provisions of the instrument
(i.e. legally bound)

Initial measurement
(i.e. 1st time you recognise it):
 Fair value of consideration paid/received i.e.
this is normally cost
 FINANCIAL ASSETS;
Subsequent measurement
Subsequent measurement
(i.e. first reporting date AFTER initial measurement)
Depends upon type of asset;
 Equity instruments;

 held for trading e.g. short term investments

– measured at fair value through IS
 held long term e.g. long term investments
– measured at fair value through IS or can
designate when acquired to be treated at
fair value through other comprehensive
income
 FINANCIAL ASSETS;
Subsequent measurement
Subsequent measurement
(i.e. first reporting date AFTER initial measurement)

 All other financial assets eg loans given to

third parties, trade receivables ; measured
either at
 Fair value through IS or

 Amortised cost BUT ONLY if satisfy 2 tests;

 Business model test

 Cash flow test

FINANCIAL ASSETS;
Business model test
Business model test

 Considers the underlying purpose for

holding the financial asset
 If the purpose is to collect contractual cash
flows this would suggest that the test has
been passed e.g. trade receivables
 If the purpose is to dispose of such financial
assets in response to changes in fair value
this would suggest that the test failed e.g.
share investments
FINANCIAL ASSETS;
Cash flow test
Cash flow test

 Considers the nature of the cash flows and

other returns
 Cash flows must be solely returns of the
principal and interest e.g. loans receivable
– amounts received would be repayment of
the capital plus interest
 Convertible debt would fail the test e.g loan
receivable that is not repaid by cash
instead it can be converted into shares
 FINANCIAL LIABILITIES;
Subsequent measurement
 After initial measurement measure
financial liabilities typically at

AMORTISED COST
 Test your understanding
MI plc has the following financial assets:
1. Investments held for trading purposes

2. Interest-bearing debt instruments that will

be redeemed in 5 years. MI plc intends to
hold them until redemption
3. A trade receivable

How should MI plc value its financial assets?

Test your understanding

Answer:
1. Fair value through income
statement
2. Amortised cost

3. Amortised cost
What’s amortised cost?
 Amortised cost takes into account
the internal rate of return and
reflects the value of the
asset/liability on the SFP at the
discounted value
 Amortised cost – an example
XYZ plc issues 2 debt instruments, each with a nominal
value of £10,000 and redeemable in 2 years. The
effective interest rate for both instruments is 10%.

Instrument 1
- has a coupon rate of 0% and is redeemed at a
premium of £2,100.

Instrument 2
- has a coupon rate of 2% and is issued at a discount
of £500 and is redeemed at a premium of £1,075.

Question:
How should these debt instruments be accounted for?
Instrument 1
 This is a financial liability to be measured at
amortised cost
 Record initially at fair value
 Carrying value at end of each year is the
amortised cost

b/f Int Payment c/f

10% 0%
Y1 10,000 1,000 nil 11,000
Y2 11,000 1,100 (12,100) nil
 Instrument 2
 This is also a financial liability to be
measured at amortised cost
 Record initially at fair value
 Carrying value at end of each year is the
amortised cost

b/f Int Payment c/f

10% 2%
Y1 9,500 950 (200) 10,250
Y2 10,250 1,025 (11,275) nil
 De-recognition (i.e. stop recognising)
 Financial assets, when:
 the contractual rights expire, or
 the FA is transferred/sold

NB: Key point is that the rights and

rewards of ownership have been
transferred.

 Financial liabilities, when the obligation is:

 discharged, or
 cancelled, or
 expires
Derivatives

What is a derivative?

 This is a financial asset or liability

which:
 Changes in value depending on interest
rates, security prices, price indices
 Little cost up front
 Pay for it at a future date
 Derivatives
 Examples:
 Forward contract (e.g: to pay a foreign supplier)
 Forward rate agreement (eg: to agree a future
rate of interest to pay/receive on a loan)
 Swaps (e.g: an interest rate swap might swap a
floating rate to a fixed rate)
 Options (e.g: the right, but not obligation, to buy
[call] / sell [put)] something in the future)

 NB: see further explanation of the above

examples on later slides
Derivatives
 Measurement:
 Initially:
 FV (exclude transaction costs) – ie: cost
 Subsequently:
 Generally, FV through income statement
(for assets and liabilities)
Forward contract - example
 Reminder: a forward contract is an
agreement to buy or sell foreign currency in
the future at an agreed rate

 Example: UK plc enters into a contract with

an overseas supplier to purchase a piece of
machinery at a price of E1,000,000 to be
settled in 2 months time. At the time of the
transaction the exchange rate was £1:E1.5
Forward contract - example

In order to protect against the exchange rate risk

UK plc enters into a forward exchange contract to
buy E1,000,000 from the bank in 2 months time at
a fixed exchange rate of £1:€1.5 (£666,666).

Say, the exchange rate deteriorated to £1:€1.4. UK

plc would have been wise to take out the forward
contract (without the contract in place it would have
now cost the company £714,285).The contract
would have a value which could be sold to another
party.
Options - example
 Reminder: An option is a ‘right’ (not an
obligation) for the holder to buy or sell at
pre-determined prices and sometimes on
specified dates

 Example (e.g. Share options): It is

common practice for plcs to offer key
management the option to purchase shares
in the company at a future date (often for a
price below market value) as part of their
overall remuneration package
Swaps - example
 Reminder: ability to swap the interest
being paid from a variable rate to a fixed
rate (or vice versa) on a loan

 Example: Company A enters into an

interest swap with Company B. The
notional amount of the swap is £1,000,000
but this amount is not exchanged. A pays
interest to B monthly at 7% and B pays
interest to A at LIBOR. If LIBOR moves
above 7% then A gains on the deal, if
LIBOR moves below 7% then A loses on the
deal.
Financial asset/liability
-v- Financial instrument

REMINDER

Financial instrument: Any contract that

gives rise to both a financial asset of one
enterprise and a financial liability or
equity instrument of another enterprise

Financial assets and liabilities: See

earlier slides (eg: cash, receivables,
payables, investments)
Quiz time!!!
Financial Financial Financial
asset liability instrument

1. Cash

2. Trade
receivables

3. Trade
payables

4. Derivatives
Quiz – Is it a financial Instrument?
 Cash
 NO! It is a financial asset, there is no
financial liability of another company
 Trade receivables and payables
 YES They are financial assets and
liabilities and there is a contract.
 Derivatives
 YES!
Lecture Example
(Balsawood Airways)
 Balsawood Airways signs a contract in
June 2017 to buy 50 Aerobus planes with
phased delivery between June and
September 2018
 Cost will be the prevailing market price of
such aircraft at the time of delivery – with
an upper limit for the contract as a whole
of $5,500m and a lower limit of $4,500
 Advanced non-returnable payment of
$500m will be required in February 2018
regardless of whether BA changes its
mind and withdraws from the contract.
Balancing payment will be made upon
delivery of the last aircraft
 Lecture Example
(Balsawood Airways)
 Is there a financial instrument?
 Yes – because there is a contract that gives “rise to
both a financial asset of one enterprise and a
financial liability or equity instrument of another
enterprise” (see definition)

Balsawood Airways:
Financial asset
–contractual right to receive 50 Aerobus planes
Financial liability –deposit payable in February 2018
and the balancing payment due later in 2018

Supplier:
Financial asset – cash received
Financial liability – contractual obligation to supply
50 Aerobus planes
Lecture Example
(Balsawood Airways)
 Is there a derivative?
 Is there a contract – Yes, BA has the contractual
right to the receipt of 50 Aerobus planes
 Does its value change in response to the change in a
specified variable – Yes, the contract becomes more
valuable if the market price of 50 Aerobus planes
increases above $5,500 (which is the maximum
BA must pay for the planes). The contract would
then have a value which could be traded
 Is there any initial investment – No cost in setting up
the contract
 Is it settled at a future date – Yes
 IT IS A DERIVATIVE. BA could sell its rights to the
planes to a third party, the value of the contract
would depend upon the movement in the market
price of the planes
IAS 32 / IFRS 7
Presentation & Disclosure

 Extensive disclosure requirements

of financial instruments within plcs
accounts
 The disclosures should provide an
overview of the entity’s use of
financial instruments and the
exposures to risks they create
 Narrative commentary as well as
monetary disclosure is required
Problems with fair value accounting of
financial instruments
 Establishing fair value of financial
instruments can be difficult and costly
 Not always an active market so difficult to
establish fair values
 Fair values can be subjective
 Fair values can fluctuate significantly year
on year causing large movements within
the statement of financial position and
comprehensive income statement
 Can record gains on fair values within the
income statement that have not yet been
realised
 Problems with fair value accounting of
financial instruments
 Immense amount of work to identify and
classify all the different financial instruments
a company may have
 Need detailed technical knowledge to
identify and account for financial
instruments
 Lack of consistency between the way that
financial instruments and trading contracts
are recognised (financial instruments
recognised from the commitment date
rather than when goods or services are
delivered)
 Increased disclosures could lead to
information overload
 What have we done today?
 Financial instruments
 What they are
 What constitutes a financial asset and financial
liability
 How we value financial assets and liabilities
 What is amortised cost
 How we show them in financial statements

 Relevant standards:
 IAS 32, IAS 39, IFRS 7 and IFRS 9

 To do:
 Extra reading:
 E&E: Chapter 12
 Prepare seminar questions