day 2 ias 32 39 financial instruments.ppt · september 2009 page 16 financial instruments financial...

Financial Instruments

September 2009 Financial Instruments

What is a financial instrument?

► A financial instrument is any contract that gives rise to both a financial asset in one entity and a financial liability or equity instrument in another entity


What is a financial asset?

► A financial asset can be cash, an equity instrument of another entity, or a contractual right to receive cash or another financial asset from another entity or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity.


What is a financial liability?

► financial liability is any contractual obligation to deliver cash or another financial asset with another entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.


What is an equity instrument?

► An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.


What is fair value?

► Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an “arm’s length transaction.”


Types of instruments

► What types of financial instruments do you know?


Types of instruments (continued)

► Cash► Bank accounts ► Loans► Leases► Deposits► Financial guarantees► Promissory notes



► Bonds► Shares► Units of unit investment funds► ADRs/GDRs► Credit linked notes (CLNs)► Collateralised debt obligations (CDOs)► Convertible bonds



► Forwards► Futures► Options► Currency swaps► Interest rate swaps► FRAs► Credit default swaps (CDS)

Overview of IAS 32 and IAS 39


IAS 32

► IAS 32 “Financial Instruments: Presentation”► Provides guidance for:

► Classification► Presentation;


IAS 39

► IAS 39 “Financial Instruments: Recognition and Measurement”► Provides guidance for:

► Recognition and derecognition► Classification► Measurement► Hedge accounting


Classification of Financial Assets

Category Main use

Fair value through profit or loss

All derivatives (outside designated hedges)Other items intended to be actively tradedAny item designated as such that meets criteria

Held-to-maturity Debt assets acquired by the entity to be held to maturity

Loans and receivables

Conventional loan assets that are unquoted (originated or acquired), trade receivables

Available-for-sale All assets not in the above categoriesIt is a residual category - does not mean that the entity stands ready to sell these


Classification of Financial Liabilities

Category Main use

Fair value through profit or loss

All derivatives (outside designated hedges)Other items intended to be actively tradedAny item designated as such that meets criteria

Other liabilities All liabilities not in the above category


Financial Instruments at FV through P&L

► A financial asset (or financial liability) at fair value through profit or loss is one that is either:► Held for trading; or► Designated at initial recognition

► A financial instrument must be classified as held for trading if it is:► Acquired or incurred principally for the purpose of selling or repurchasing

it in the near term;► Part of a portfolio of identified financial instruments that are managed

together and for which there is evidence of a recent actual pattern of short-term profit-taking; or

► A derivative (except for designated and effective hedging instruments)

Debt vs. Equity


Debt vs. Equity

► IAS 32 provides principles for the distinction between liabilities and equity classification

► Substance over legal form (in theory)► Liability = Issuer can be required or has the option to

deliver cash► Equity = Represents a residual interest in the net assets

of the Issuer


Debt vs. Equity (continued)

► Financial instruments (compound instruments) that contain both a liability and equity component must be split and accounted for separately.

► The liability component is determined by fair value of expected cash flows (excluding the equity component) and the residual is allocated to the equity component.

Measurement


Fair Value at Initial Recognition

► The best evidence of the fair value at initial recognition is the transaction price (i.e., the fair value of the consideration given or received) unless: ► The fair value of that instrument is evidenced by comparison with

other observable current market transactions in the same instrument (ie, without modification or repackaging); or

► Based on a valuation technique whose inputs include only data from observable markets


Fair Value – Active Market

► Published price quotation in an active market is the best evidence of fair value and must be used to measure fair value where possible► Fair value of portfolio of financial instruments is the product of

number of units of the instrument and its quoted market price► No block discounts allowed due to the size of the position


Fair Value – Inactive Markets

► When current bid or offer prices are unavailable, price of the most recent transaction provides evidence of fair value► If conditions have changed since the transaction the fair value

reflects the change by reference to current prices or rates for similar financial instruments

► If the entity can demonstrate that the last transaction is not fair value the price is adjusted


Fair Value – Inactive Markets (continued)

► If market is not active an entity establishes fair value using a valuation technique. For example:► Most recent arm’s length transaction between knowledgeable, willing

parties;► Reference to fair value of a similar instrument;► Discounted cash flow; or► Option pricing models.

► The valuation technique used must:► Incorporate all factors that market participants would consider in setting a

price; and ► Be consistent with accepted economic methodologies for pricing financial

instruments.


Effective Interest Method

► The rate that exactly discounts estimated future cash flows through the expected life of the financial instrument (or when appropriate, a shorter period) to the net carrying amount of the instrument► A method of allocating the interest income or expense over the

relevant period; and► Of calculating the amortised cost


Illustration of Effective Yield Method

► Bond with issue value of 1,000,000 pays 5% for 2 years, then 7% thereafter, annually on anniversary of issue.

► Option to prepay or extend after 4 years.► The holder does not anticipate the cash flows extending

beyond year 4.


Illustration of Effective Yield Method (continued)

Year b/f Cash Interest c/f1 1,000,000 (50,000) 59,424 1,009,424

2 1,009,424 (50,000) 59,983 1,019,407

3 1,019,407 (70,000) 60,577 1,009,984

4 1,009,984 (1,070,000) 60,017 0

Yield 5.94235%

Impairment


General Impairment Rules

► A financial asset is impaired when:► Carrying amount > Estimated recoverable amount ► Must assess for evidence of impairment at each balance sheet

date

► If any evidence of impairment, must estimate the recoverable amount and recognise any impairment loss

► Incurred loss model rather than an expected loss model


Impairment – Available-for-sale Assets

► Guidelines for objective evidence of impairment for equity instruments► A significant or prolonged decline in fair value below the cost now

represents objective evidence of impairment ► No concept of temporary

► Impairment on equity instruments cannot be reversed► Impairment on debt instruments can be reversed, under

certain circumstances


Impairment – Amortised Cost Assets

► Guidelines for objective evidence of impairment► Separate assessment for those individually significant► Collective impairment assessment does not equal general

provisions and/or Basel II


Objective Evidence?

► At each balance sheet date an entity must assess if there is objective evidence of impairment.

► Objective evidence includes:► Financial difficulty of issuer;► Default or delinquency, or concessions by lender;► High probability of bankruptcy or financial reorganisation;► Disappearance of active market in investment due to financial problems;► Historical pattern of collections of a group of financial assets that implies

that holder will not collect all amounts due.


Collective Assessment

► Collective assessment for amortised cost financial assets includes:

1. Groups of similar financial assets that are not individually significant; and

2. Individually significant financial assets reviewed with no required impairment

3. Recognition of losses known to exist in the portfolio but not yet evident

IFRS 7 Financial Instruments: Disclosures


IFRS 7 Objective

► To provide information ► to enhance understanding of the significance of financial

instruments to an entity’s ► financial position, ► performance, and ► cash flows

► to assist in assessing the amounts, timing, and certainty of future cash flows associated with those instruments.

► Aims to provide the information in the context of risks


IFRS 7 Risks arising from Financial Instruments

Typical risks arising from financial instruments

Credit risk Market riskLiquidity risk

Currency riskInterest rate risk

Prepayment risk

Other price risks

Share price Recovery riskCommodities price


► For each type of risk arising from financial instruments to which an entity is exposed at the reporting date, it shall disclose summarised quantitative dataØ The disclosures have to be based on the information provided

internally to key management personnel, for example, the entity’s board of directors or chief executive officer.

IFRS 7 Quantitative Disclosures


Conclusion

►Questions?

day 2 ias 32 39 financial instruments.ppt · september 2009 page 16 financial instruments financial...

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