ACCT312 Financial Instruments

Financial instrument

Any contract which gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity

Primary FI

A FI whose price is based directly on its market value (e.g. accounts receivable, cash)

Derivative FI

- instrument that creates rights and obligations with the effect of transferring one or more of the financial risks inherent in an underlying FI

Has to have the following three characteristics:

1. Its value changes in response to the change in the underlying security/rate/credit rating

2. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

3. It is settled at a future date

Why do FI's raise specific issues for financial reporting?

- complexity: some of the instruments are very complex and hard to understand (e.g. swaps). Which leads to them being time consuming for those who have to set the standards and those using them

- risk and uncertainty: FI's always deal with the future so dont know what it is going to be (e.g. share price). Difficult to measure and record

- judgement: a lot is required for those implementing standards, firms judgements may be different so may be interpreted differently

Set-off

Entity may wish to perform one to reduce gearing ratios such as debt to asset, or debts to shareholders' funds

Why do compound FI's raise issues for accountants?

- key issue is the distinction between debt and equity

- usually entities prefer equity to debt

- however, compound FI's have both a debt and an equity aspect, so how to account for them is a key concern

Identifying the PV of bonds and allocating the difference between the PV and the issue price to the equity component

- in considering how to measure the liability and equity components of the convertible bonds, we can determine the PV of the cash flows at the market's required rate of return

- this amount would represent the liability component of convertible bonds

- the difference between the liability component and the total issue price of the bonds would represent the equity component

PV of principal

FV bonds x (Pv of $1 table)

PV of interest stream

Interest rate x FV bonds= interest payment

Interest x (PV of annuity table)

Working out equity component

- work out PV of principal and PV of interest stream

- then bond - PV of principal and interest

- equity component and PV's should equal the FV of the bonds

Journal entry for allocating PV (liability) and equity components

Dr Cash at bank

Cr Convertible bonds (liability)

Cr Convertible bonds (equity)

Calculating interest stream bond liabilities table

Interest expense= bond liability x conversion rate

Increase in bond liability= interest expense - interest payment

Bond liability= previous years bond liability + increase in bond liability

- do for each year, first year should already have the bond liability

- bond liabilities should equal in total the FV of bond

Journal entry for interest stream table

Dr Interest expense (int exp)

Cr Cash (int pmt)

Cr Convertible bonds (liability) (inc. in bond liab.)

Journal entries if elect to convert options to ordinary shares

Dr Interest expense

Cr Cash

Cr Convertible bonds (liability)

Dr Convertible bonds (liability)

Dr Convertible bonds (equity)

Cr Ordinary share capital

Journal entries for option to convert to ordinary shares (but no equity component instead option to convert)

Dr Cash

Cr Convertible note liability (principal + interest amount)

Cr Option to convert

Dr Interest expense

Cr Cash

Cr Convertible note liability

(interest expense using convert rate x principal + interest amount)

Dr Convertible note liability

Dr Option to convert

Cr Ordinary share capital

Equity instrument

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

Compound FI's

Incorporate both:

- financial liabilities; and

- equity instruments

Offsetting

A FA and FL shall be offset and the net amount presented in the statement of financial position when, and only when, an entity has:

(a) A currently legally enforceable right to set off the recognised amounts; and

(b) The entity intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously

Derecognition

The removal of a previously recognised FA or FL from an entity's statement of financial position

Hedge accounting

- is like insurance

- objective: to represent in the FS's, the effect of an entity's risk management activities that use FI's to manage exposures arising from particular risks that could affect P+L

- trying to transfer risk for something that may happen in the future

Hedging instrument

A derivative measured at FV through P+L may be designated as a hedging instrument, except for some written options

Hedged item

A recognised asset or liability, an unrecognised firm commitment, a forecast transaction or a net investment in a foreign operation

Three types of hedging relationships

1. FV hedge

2. Cash flow hedge

3. Hedge of net investment in a foreign operation

1. FV hedge

To mitigate the risks associated with exposure to changes in the FV of a recognised asset or liability, or an unrecognised firm commitment

- e.g. a futures contract to hedge the value of an equity investment

2. Cash flow hedge

To mitigate the risk of changes in the future cash flows associated with an asset or liability or a highly probable forecast transaction

- e.g. a forward contract to cover the exchange risk of an overseas sale transaction

Disclosures

- large number of disclosure requirements in NZ IFRS 7

- risks to be disclosed relate to: credit risk, liquidity risk and market risk