Financial Instruments – Comprehensive Study Notes (MFRS 132)

Definition & Objective of MFRS 132

• Financial Instrument (FI)
  • Any contract that gives rise simultaneously to:
  • A financial asset (FA) of one entity, and
  • A financial liability (FL) or an equity instrument (EI) of another entity.
• Contract = agreement between ≥ 2 parties with clear economic consequences that the parties cannot avoid (usually enforceable at law).
• Objective of MFRS 132 = prescribe presentation principles for FIs from the issuer’s perspective, including the distinction between FA, FL and EI.

Classification of Financial Instruments

• Three basic categories:
  • Financial Asset
  • Financial Liability
  • Equity Instrument

Financial Assets

• An asset is a FA when it is:
  1. Cash.
  2. Equity instrument of another entity.
  3. Contractual right:
  • to receive cash/another FA, or
  • to exchange FAs/FLs on potentially favourable terms.
  1. Contract settled in own equity instruments when either:
  • Non-derivative: entity will/may receive a variable number of own shares.
  • Derivative: will/may be settled otherwise than by exchanging a fixed amount of cash/FA for a fixed number of own shares.
• Common examples:
  • Trade receivables, investments in another entity’s shares or bonds, fixed deposits.
• NOT FAs: inventories, PPE, intangibles such as trademarks & goodwill ⇒ they provide control & future inflows but no present contractual right to cash/another FA.

Financial Liabilities

• An instrument is a FL when it embodies a contractual obligation to:
  1. Deliver cash/another FA; or
  2. Exchange FAs/FLs on potentially unfavourable terms; or
  3. Settle in own equity instruments when either:
  • Non-derivative: issuer must deliver a variable number of own equity instruments; or
  • Derivative: will/may be settled other than by exchanging a fixed amount of cash/FA for a fixed number of own shares.
• Examples: trade payables, bank loans, bonds & debentures.
• Income-tax liabilities are not FLs (statutory, not contractual).

Equity Instruments

• Any contract that evidences a residual interest in the assets after deducting all liabilities.
• Examples: ordinary shares, preference shares without mandatory redemption, equity component of compound instruments, share options.

Illustration – Milo Bhd vs Cocoa Bhd

• Facts: Cocoa will settle Milo’s receivable either with cash or by assigning another receivable (Ovaltine Bhd).
• Both settlement alternatives are FAs.
• Contract exists ⇒ FI exists. Milo records a FA; Cocoa records a FL.

Primary vs Derivative Instruments

• Primary (non-derivative) instruments: value derives directly from markets (e.g. receivables, payables, ordinary shares).
• Derivatives: contracts that
  1. Change value with an underlying (interest rate, price, FX, etc.);
  2. Require little/no initial net investment;
  3. Are settled at a future date.
  • Examples: options, futures, forwards, interest-rate swaps, currency swaps.

Worked Examples – Primary Contracts

• Example 1.1a (goods order): Contract on 1 Jan for delivery of goods (no cash right/obligation) ⇒ not FI until settlement terms specify a FA.
• Example 1.1b settlement variants (1 Feb):
  1. Cash → FI (FL for FLB; FA for FAB).
  2. Transfer of another receivable → FI.
  3. Transfer of equity shares in BT S/B → FI.
  4. Transfer of land → not FI (non-FA).
  5. Issue of FLB’s own shares → FI; additionally within MFRS 2 (share-based payment).
• Example 1.2 (failure to pay, replacement by variable own shares): original cash contract replaced by settlement in a variable number of own shares ⇒ still within MFRS 132/139; FL remains until settlement.

Worked Examples – Derivatives

• Example 2.1 (cash vs floating-rate bond future):
  • Both items are FAs ⇒ contract is within MFRS 132/139.
  • If bond market price ↑ to RM110 k → favourable to AA (FA), unfavourable to BB (FL); vice-versa if price ↓ to RM90 k.
• Example 2.2 (variable own shares vs bonds):
  • Settlement = variable number of AA’s own shares for 1,000 bonds; value fluctuates ⇒ derivative within scope.
  • FA for BB (seller), FL for AA (purchaser).

Substance Over Legal Form

• Classification follows economic substance, not legal label.
  • E.g. redeemable preference shares legally equity but substantively liability because issuer must redeem for fixed cash amount.
• If no obligation to deliver cash/another FA or to exchange on unfavourable terms ⇒ equity.
  • E.g. employee share options (fixed-for-fixed) are equity.

Puttable Instruments

• Give holder right to return instrument to issuer for cash/another FA ⇒ normally FL.
• However, may be classified as equity if all criteria met:
  a) Entitles holder to proportionate share of net assets on liquidation.
  b) Is the most subordinate class (no priority; non-convertible).
  c) Issuer has no other contractual obligation for cash/FA.
  d) Total cash flows limited to profit/loss or changes in recognised net assets/fair value.

Additional Conceptual Examples

• Jet-fuel purchase contract: must take physical delivery; no financial settlement ⇒ not FI.
• Cash, gold bullion, notes receivable in a deposit box:
  • Cash & notes receivable = FA; gold bullion ≠ FA.
• Silver forward with net-settlement alternative: meets derivative definition (underlying = silver price, no initial net investment, future settlement, notional 1 million kg).

Exam Example (April 2010 – Eg 2)

• (i) Forward bond vs cash: derivative.
  • If bond price ↑ → Malam has FA, Siang has FL.
• (ii) Irredeemable instruments with discretionary dividends & residual interest: no contractual cash obligation ⇒ equity instruments.

Compound Instruments (e.g. Convertible Bonds)

• Feature both liability & equity elements; issuer must separate on initial recognition and NEVER re-measure allocation.
• Liability component = present value of cash flows (principal + interest) discounted at market rate for similar debt without conversion option.
• Equity component = residual (proceeds – liability).
• Illustration Example 9 (p172):
  • Issue: 10 000 × RM1 000 convertible bonds, coupon 7 %, term 3 yrs; market rate (no option) = 10 %.
  • Present value of cash flows:
    \text{PV}\text{interest}=700{,}000\times 0.9091 + 700{,}000\times 0.8266 + 700{,}000\times 0.7513 = RM1{,}214{,}850 \text{PV}\text{principal}=10{,}000{,}000\times 0.7513 = RM7{,}538{,}910
    \text{Liability component}= RM9{,}253{,}760
    \text{Equity component}= RM10{,}000{,}000 - 9{,}253{,}760 = RM746{,}240
  • SOFP extract (1 Jan 20×1):
    • Equity – equity component of bonds: RM746 240
    • Non-current liabilities – 7 % convertible bonds: RM9 253 760
• Preference shares that are non-cumulative but redeemable → compound.
  • Liability portion = PV of redemption price; equity portion = residual; ensuing dividends treated as equity distributions.

Presentation of Income & Changes in Equity

• Items on an instrument classified as liability: interest, dividends, gains, losses → profit or loss.
• Dividends on instruments classified as equity → directly deducted from equity.
• Issue/acquisition costs of own equity → deducted from equity (unless transaction abandoned → expense).
• Transaction costs on compound instruments → allocated between liability & equity in same proportion as proceeds.
• Gains/losses on redeeming/refinancing liabilities → P&L.

Treasury Shares

• Repurchased own shares (not cancelled).
• Recognised as deduction from equity (not FA).
• No gain/loss recognised on purchase, sale, issue or cancellation.

Offsetting FA & FL

• Report net only if BOTH conditions met:
  1. Legally enforceable right to set off.
  2. Intention to settle net or realise asset & settle liability simultaneously.
• Example 12 (FB & Vigi): Receivable RM10 m & payable RM10 m with same counterparty:
  • Present net only if legal right + intention; otherwise show gross FA & FL.

Practical & Ethical Implications, Connections

• Substance over form promotes faithful representation, discourages structuring transactions merely for desired presentation.
• Mis-classification can distort leverage ratios, dividend capacity & covenant compliance.
• Links to prior study:
  • MFRS 9 recognition/measurement rules build on categories defined here.
  • MFRS 2 share-based payment applies where own-equity instruments are used for settlement.
• Investors, regulators and auditors rely on consistent application to assess risk, solvency and performance.
• Ethical duty: avoid deliberately mis-classifying redeemable shares or compound instruments to manipulate EPS or debt ratios.

Quick Reference Formulae & Definitions

• PV of Liability Component (convertible bond):
  \sum_{t=1}^{n}\frac{\text{Coupon}\times \text{Face}}{(1+r)^t} + \frac{\text{Redemption}\;\text{Value}}{(1+r)^n} where r = market yield for similar non-convertible debt.
• Fixed-for-Fixed Test (equity): settlement is fixed amount of cash (or no cash) for a fixed number of own shares ⇒ equity; otherwise ⇒ FL/derivative.

Exam Tips

• Always identify:
  1. Existence of a contract.
  2. Whether rights/obligations concern cash/another FA or own shares.
  3. If own shares involved, apply fixed-for-fixed criterion.
• Separate compound instruments at issuance, never re-allocate later.
• Provide numerical workings (PV) when converting convertible bonds or redeemable preferences.
• Mention derivative criteria (underlying, no/low initial investment, future settlement) when relevant.
• Reconcile legal form with economic substance to avoid traps (e.g. redeemable prefs ≠ equity).