Gripping IFRS Financial instruments

Chapter 21

646

Chapter 21

Financial Instruments

Reference: IAS 32; IAS 39 and IFRS 7 Contents:

Page

1. Introduction

648

2. Definitions Example 1: financial assets Example 2: financial liabilities

648 648 649

3. Financial Risks 3.1 Overview 3.2 Market risk

3.2.1 Interest rate risk 3.2.2 Currency risk 3.2.3 Price risk

3.3 Credit risk 3.4 Liquidity risk

649 649 649 649 649 650 650 650

4. Derivatives 4.1 Options 4.2 Swaps

Example 3: swaps 4.3 Futures

650 650 650 650 651

5. Compound financial instruments Example 4: splitting of compound financial instruments Example 5: compulsorily convertible preference shares Example 6: redeemable debentures issued at a discount

651 652 653 654

6. Categories of financial liabilities 6.1 Overview 6.2 Financial liabilities measured at fair value through profit and loss

Example 7: fair value through profit and loss 6.3 Financial liabilities not measured at fair value through profit and loss

Example 8: other financial liabilities

656 656 656 657 657 657

7. Categories of financial assets 7.1 Overview 7.2 Fair value through profit or loss

Example 9: fair value through profit or loss financial assets 7.3 Held to maturity financial assets

Example 10: held to maturity 7.4 Loans and receivables

Example 11: loans and receivables 7.5 Available for sale financial assets

Example 12: available for sale

658 658 658 658 659 659 659 660 660 660

Gripping IFRS Financial instruments

Chapter 21

647

Contents continued:

Page

8. Reclassification of financial instruments 8.1 Overview 8.2 Fair value through profit or loss 8.3 Held to maturity 8.4 Available for sale 8.5 Instruments previously measured at amortised cost

661 661 661 661 661 661

9. Impairment of financial instruments

661

10. Offsetting of financial assets and liabilities

661

11. Disclosure Example 13: disclosure of financial instruments

662 663

12. Summary

666

Gripping IFRS Financial instruments

Chapter 21

648

1. Introduction Most students find the financial instruments section very difficult, but by simply learning and understanding the various definitions and rules, it will be made a lot easier. The IAS and IFRS standards covering the recognition, measurement and disclosure of financial instruments are very long, and therefore this chapter contains only the most important aspects.

2. Definitions The definitions that follow may be found in IAS 32 and 39. Financial instrument: is any contract that gives rise to a financial asset in one entity and a financial liability or equity instrument in another. The contract need not be in writing. An equity instrument: is any contract that results in a residual interest in the assets of an entity after deducting all of its liabilities A financial asset: is any asset that is: cash; an equity instrument of another entity; a contractual right to receive cash or another financial asset from another entity; a contractual right to exchange financial instruments with another entity under conditions

that are potentially favorable to the entity; or a contract that will or may be settled in the entitys own equity instruments and is: - a non-derivative for which the entity is or may be obliged to receive a variable number of

the entities own equity instruments; or - a derivative that will or may be settled other than by the exchange of a fixed amount of

cash or another financial asset for a fixed number of the entitys own equity instruments. A financial liability: is a liability that is: a contractual obligation to deliver cash or another financial asset to another entity; a contractual obligation to exchange financial instruments with another entity under

conditions that are potentially unfavorable to the entity; a contract that will or may be settled in the entitys own equity instruments and is: - a non-derivative for which the entity is or may be obliged to deliver a variable number of

the entitys own equity instruments; or - a derivative that will or may be settled other than by the exchange of a fixed amount of

cash or another financial asset for a fixed number of the entitys own equity instruments. Compound instruments: are instruments that contain both a liability and equity component. A derivative: is a financial instrument or other contract with all three of the following characteristics: its value changes in response to a change in a specified interest rate, financial instrument

price, foreign exchange price etc; 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

is settled at a future date. Derivatives are commonly used to manage financial risks. Example 1: financial assets Discuss whether any of the following are financial assets: a. Inventory b. Debtors c. Cash d. Property, plant and equipment

Gripping IFRS Financial instruments

Chapter 21

649

Solution to example 1: financial assets a. No, there is no contractual agreement to receive cash or otherwise simply by holding stock. b. Yes, there is a contractual right to receive a payment of cash from the debtor. c. Yes, it is cash d. No, there is no contractual right to cash or another instrument by owning property, plant and

equipment. Example 2: financial liabilities Discuss whether any of the following are financial liabilities: a. Creditors b. Redeemable preference shares c. Warranty obligations d. Bank loans Solution to example 2: financial liabilities a. Yes, the entity is contractually obligated to settle the creditor with cash. b. Yes, the entity must, in the future, redeem the preference shares with cash. c. If the entity has to pay the warranty obligation in cash, it is a financial liability. If the entity

merely has to repair the goods, then, since there is no obligation to pay cash or any other financial instrument, it is not a financial liability.

d. Yes, there is a contractual obligation to repay the bank for the amount of cash received plus interest.

3. Financial risks

3.1 Overview There are three categories of financial risks and they are: market risk (affected by price risk, interest rate risk and currency risk); credit risk; and liquidity risk. 3.2 Market risk (IFRS7; Appendix A) Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises of: interest rate risk; currency risk; and other price risk. 3.2.1 Interest rate risk Interest rate risk is the risk that the value of the instrument will fluctuate with changes in the market interest rate. A typical example is a bond: a bond of C100 earning a fixed interest of 10% (i.e. C10) would decrease in value if the market interest rate changed to 20%, (theoretically, the value would halve to C50: C10/ 20%). If the bond earned a variable interest rate instead, the value of the bond would not be affected by interest rate fluctuations.

3.2.2 Currency risk Currency risk is the risk that the value of the instrument will fluctuate because of changes in the foreign exchange rates. A typical example would be where we have purchased an asset from a foreign supplier for $1 000 and at the date of order, the exchange rate is $1: C10, but where the local currency weakens to $1: C15. The amount owing to the foreign creditor has now grown in local currency to C15 000 (from C10 000).

Gripping IFRS Financial instruments

Chapter 21

650

3.2.3 Price risk Price risk is the risk that the value of the financial instrument will fluctuate as a result of changes in the market prices. For example: imagine that we committed ourselves to purchasing 1 000 shares on a certain date in the future, when the share price was C10 on date of commitment. By making such a commitment, we would be opening ourselves to the risk that the share price increases (e.g. if the share price increased to C15, we would have to pay C15 000 instead of only C10 000). 3.3 Credit Risk This is the risk that the one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss. A typical example is a debtor, being a financial asset to the entity, who may become insolvent and not pay the debt due (i.e. where a debtor becomes a bad debt). 3.4 Liquidity Risk This is the risk that the entity will encounter difficulty in raising funds to meet commitments associated with the financial instrument. An example would be where we (the entity) found ourselves with insufficient cash to pay our suppliers (i.e. where we become a bad debt to one of our creditors).

4. Derivatives There are many types of derivatives of which we discuss a few: 4.1 Options An option gives the holder the opportunity to buy or sell a financial instrument on a future date at a specified price. The most common option that we see involves options to buy shares on a future date at a specific price (strike price). These are often granted to directors or employees of companies. Another example is an option to purchase currency on a future date at a specific exchange rate. Options may be used to limit risks (as the exercise price of an option is always specified) or they may be used for speculative purposes (i.e. to trade with). 4.2 Swaps A swap is when two entities agree to