AF2203: L8 (Financial Instruments)

financial instrument

any contract that gives rise to a financial asset of one party and a financial liability/equity instrument of another party

FA

non-physical A that gets value from a contractual right/ownership claim

FL

contractual obligation to deliver cash/FA to an entity

equity instrument

any contract that evidences a residual interest in the assets of an entity after deducting all liabilities

compound financial instruments

contains both E/L components

• ex. contingent convertible bonds

CoCos

high-yield, hybrid debt securities issue by banks to absorb losses during financial distress by automatically converting to equity/being written down if bank’s capital falls below a threshold

nominal IR

stated/contractual IR

int received/paid on FA/FL

principal amount * NIR

effective IR

actual rate paid/earning after accounting for compounding

• makes PV of future CFs = carrying of A/L

int income/expense on FA/FL

opening balance * EIR

3 standards related to FIs

• IAS32: financial instruments: presentation

• IFRS9: financial instruments

• IFRS7: financial instruments: disclosures

IAS32

financial instruments→ presentation: prescribes accounting for classifying/presenting FIs

• key idea: FI substance, rather than legal form, governs its classification

IFRS9

financial instruments: requirements for recognition/measurement of FIs

measuring FAs under IFRS9

initial recognition: FV

subsequent measurement: one of 3 options→

• amortized cost

• FVOCI

• FVPL

2 tests to classify FAs

• business model test:

  • asset held to collect CFs

  • asset held to collect CFs and sell

  • asset held to sell

• SPPI test:

  • payments are solely principal/interest

  • payments aren’t solely principal/interest

what FAs are subsequently measured w/ amortized cost

those held to collect CFs with SPPI

• ex. coupon bonds held to maturity

what FAs are subsequently measured w/ FVOCI

those held to collect CFs and sell with SPPI

• ex. coupon bonds held for a coupon and then sold

what FAs are subsequently measured w/ FVPL

• those held to collect CFs and/or sell

  • ex. common shares/convertible bonds

• those held to sell w/ SPPI

  • ex. FAs held to trade

measuring FLs under IFRS9

initial recognition: FV

subsequent measurement: amortized cost

• exceptions: FLs held for trading → measure at FVPL

  • ex. short positions in derivative liabilities

amortized cost formula

CL = OP of FA(FL) + int income(expense) - int received(paid) - principal repayments

what method can be only one type of A/L?

only FAs can be measured FVOCI

FVOCI method

SOFP:

• recognized at FV

SOCI:

• int income/divs recognized in P&L

• gains/losses on FV movements recognized in OCI

FVPL method

SOFP:

• recognized at FV

SOCI:

• gains/losses on FV movements recognized in P&L

• for FL, FV gains/losses attributable to changes in credit risk are in OCI

how amortized cost vs FVOCI impacts firm investments

whether companies hold bonds to maturity or sell before depends largely on interest rate environment

• high IR = sell = FVOCI, don’t want to be locked in

• low IR = hold = amortized, more stable

CS: Lloyd’s Bank

• Lloyd’s anticipated rate hikes in 2022 and sold lots of their bond portfolio, switching to FAs that could be measured w/ amortized cost

impairments

• FAs may be impaired (loan default)

  • Dr. impairment expense, Cr. loss allowance (contra-asset)

• Allowance losses are based on expected credit losses using:

  • 12-month expected credit losses

  • lifetime expected credit losses (if significant credit risk increase)

IFRS7

financial instruments→ disclosures: requires disclosures about significance of FIs to the entity and the nature/extent of risks arising from those FIs