Financial Instruments

IAS 32 – FINANCIAL INSTRUMENTS: PRESENTATION

The objective of IAS 32 is ‘to enhance financial statement users’ understanding of the significance of on

Statement of Financial Position and off Statement of Financial Position financial instruments to an entity’s financial position, performance and cash flows’

The standard should be applied to the presentation of all types of financial instruments, whether recognised or unrecognised. Certain items are excluded including subsidiaries, associates, joint ventures and insurance contracts.

Definitions

Financial Instrument:  any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial asset:  any asset that is

  1. Cash
  2. An equity instrument of another entity
  3. A contractual right to receive cash or another financial asset from another entity; or to exchange financial instruments with another entity under conditions that are potentially favourable to the entity; or
  4. A contract that will or may be settled in the entity’s own equity instruments and is:
    • A non derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
    • A derivative that will or may be settled other than by the exchange of a fixed amount of cash or other financial asset for a fixed number of the entity’s own equity instruments

 

Financial Liability:  any liability that is:

A contractual obligation:

    • To deliver cash or another financial asset to another entity; or
    • To exchange financial instruments with another entity under conditions that are potentially unfavourable; or
    • A contract that will or may be settled in the entity’s own equity instruments and is:
      • A non derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own instruments, or
      • A derivative that will or may be settled other than by exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

 

Equity instrument:     any contract that evidences a residual interest in the assets of an entity after deducting its liabilities

Fair value:   the amount that an asset could be exchanged, or a liability settled, between informed and willing parties, in an arm’s length transaction, other than in a forced or liquidation sale

Derivative:   a financial instrument or other contract with all three of the following characteristics:

  • Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable
  • 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
  • It is settled at a future date Liabilities and Equity

Financial Instruments should be presented according to their substance and not merely their legal form. Entities that issue financial instruments should classify them as either equity or financial liabilities.

The classification depends on the following:-

  • The substance of the contractual arrangement on initial recognition
  • The definitions of a financial liability and an equity instrument.

The main difference between a liability and an equity instrument is the fact that an equity instrument has no obligation to transfer economic benefits.

Compound Financial Instruments

Some financial instruments contain both a liability and an equity element. IAS 32 requires the financial instrument to be split between the component parts and separately presented on the statement of financial position.

One of the most common types of component financial instruments is convertible debt. This contains a primary financial liability for the entity but also gives the holder an option to convert to equity. Basically this is identical to a liability and a warrant to issue equity.

IAS 32 requires the following for compound financial instruments a.     Calculate the value of the liability component

  • Deduct this from the instrument as a whole to leave a residual value for the equity element

Interest, Dividends, Losses and Gains

IAS 32 also considers how financial instruments affect the statement of comprehensive income. The effect depends on whether interest, dividends, losses or gains relate to the instrument.

  • Interest, dividends, losses or gains relating to a financial instrument classified as a financial liability should be recognised as income or expense in profit and loss
  • Distributions to holders of a financial instrument classified as an equity instrument should be debited directly to equity by the issuer
  • Transaction costs of an equity transaction shall be accounted for a deduction from equity (unless they are directly attributable to the acquisition of a business, in which case they are accounted for under IFRS

Disclosure of Financial Instruments

‘The purpose of the disclosure required by this standard is to provide information to enhance understanding of the significance of financial instruments to an entity’s financial position, performance and cashflows and assist in assessing the amounts, timing and certainty of future cashflows associated with those instruments’ (IAS32)

In addition to monetary disclosures, narrative disclosures are also required.

Terms

Market risk – one of currency, interest or price risk

Currency risk – is the risk that the value of a financial instrument will fluctuate to changes in foreign exchange rates

Interest rate risk – is the risk that the value of a financial instrument will fluctuate due to changes in market interest rates

Price risk – is the risk that the value of a financial instrument will fluctuate as a result of changes in market prices whether those changes are caused by factors specific to the individual instrument or its issuer or factors affecting all securities traded on the market

Credit risk – is the risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss

Liquidity risk – is the risk that an entity will encounter difficulty in raising funds to meet commitments associated with financial risk. Liquidity risk may result from an inability to sell a financial asset quickly at close to its fair value

Information to be Disclosed

Information must be disclosed about the following:-

  • Risk management policies and hedging strategies
  • Terms, conditions and accounting policies
  • Interest rate risk
  • Credit risk
  • Fair value
  • Material items of income, expense, gains and losses resulting from financial assets and liabilities.

 

     IAS 39 – FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT

IAS 39 applies to all entities and to all types of financial instruments except those specifically excluded, as listed below, for example most investments in subsidiaries, associates and joint ventures.

Example of initial recognition

An entity has entered into two separate contracts:

  • A firm commitment to buy a specific amount of copper
  • A forward contract to buy a specific quantity of copper an a firm date at a specified price

Contract A is a normal trading contract and contract B is a financial instrument.

For contract A, the entity does not recognise a liability for the copper until the goods have been delivered. The contract is not a financial instrument as it involves a physical asset as opposed to a financial asset.

For contract B, the entity recognises a financial liability (obligation) on the commitment date, rather than waiting for the closing date in which the exchange takes place.

Derecognition

An entity should derecognise a financial asset when:

  • The contract rights to the cashflows from the asset expire; or
  • It transfers substantially all the risks and rewards of ownership of the financial asset to another party

An entity should derecognise a financial liability when it is extinguished, ie when the obligation specified in the contract is discharged, cancelled or expires. A financial liability may be partially derecognised if only part of the obligation is removed.

Measurement of Financial Instruments

Financial instruments are initially measured at the fair value of the consideration given or received, plus/minus transactions costs directly attributable to the acquisition or issue of the financial instrument.

The exception to this is where the financial instrument is designated as at fair value through profit or loss. In this case transaction costs are not added/subtracted from or to fair value at initial recognition.

If the fair value is not readily available at recognition date it must be estimated using an appropriate technique.

Subsequent Measurement

After initial recognition all financial instruments should be re-measured to fair value without any deduction for transaction costs that may be incurred on sale of or other disposal, except for: a. Loans and receivables

  • Held to maturity investments
  • Investments in equity instruments that do not have a quoted market price in an actively traded market and whose fair value cannot be reliably measured and derivatives thatare linked to and must be settled by delivery of such unquoted equity instruments.

Loans and receivables and held to maturity investments should be measured at amortised cost using the effective interest method.

Investments whose fair value cannot be reliably measured should be measured at cost.

Classification

Any financial instrument can be designated at fair value through profit or loss. This however is a one off choice and has to be made on initial recognition. Once classified in this way, a financial instrument cannot be reclassified.

For a financial instrument to be held to maturity it must meet certain criteria. These criteria are not met if:-

  • The entity intends to hold the financial asset for an undefined time
  • The entity stands ready to sell the asset in response to changes in interest rates or risks, liquidity needs and similar factors
  • The issuer has a right to settle the financial asset at an amount significantly below its amortised cost
  • It does not have the resources available to continue to finance the investment until maturity
  • It is subject to an existing legal or other constraint that could frustrate its intention to hold the financial asset to maturity

 

There is a penalty for selling or reclassifying an asset that was designated as held to maturity. If this has occurred during the current financial year or during the two preceding financial years then no asset can be classed as held to maturity.

Subsequent Measurement of Financial Liabilities

After initial measurement all financial liabilities must be measured at amortised cost, with the exception of financial liabilities at fair value through the profit and loss. These should be measured at fair value but if the fair value cannot be reliably measured they should be shown at cost.

Gains and Losses

Instruments held at fair value through profit or loss: gains are recognised through profit and loss.

Available for sale financial assets: gains and losses are recognised in reserves and on disposal of the asset the balance in equity is transferred to the profit and loss account to allow the profit/loss on disposal be calculated.

Financial instruments carried at amortised cost: gains and losses are recognised in profit and loss as a result of the amortisation process and when the asset is derecognised.

Financial assets and financial liabilities that are hedged items: special rules apply.

Impairment and Uncollectability of Financial Assets

At each Statement of Financial Position date the entity must assess whether there is any objective evidence that a financial asset or group of assets is impaired. Where there is objective evidence of impairment, the entity should determine the amount of impairment loss.

Financial Assets Carried At Amortised Cost

Recognise the impairment in the profit and loss account

Financial Assets at Cost

Recognise the loss in the profit and loss account. Such impairments cannot be reversed.

Available For Sale Financial Assets

Impairments should also be recognised in the profit or loss.

 

 IFRS 7 – FINANCIAL INSTRUCTMENTSL: DISCLOSURES

Objectives

The objectives of the standard are:

  • Add certain new disclosures about financial instruments to those currently required by IAS 32
  • Puts all financial instruments disclosures in a new standard. (The remaining parts of IAS 32 deal only with presentation matters).

Disclosure Requirements

An entity must group its financial instruments into classes of similar instruments and make disclosures by class (when disclosures are required).

IFRS 7 identifies two main categories of disclosures:

  • Information about the significance of financial instruments
  • Information about the nature and extent of risks arising from financial instruments.

Information about the Significance of Financial Instruments

Statement of financial Position:

  • Disclosure of the significance of financial instruments for an entity’s financial position and performance
  • Special disclosures about financial assets and financial liabilities designated to be measured at fair value through profit and loss
  • Reclassifications of financial instruments from fair value to amortised cost or vice versa
  • Information about financial assets pledged as collateral (or held as collateral)
  • Reconciliation of the allowance account for credit losses (bad debts)
  • Information about compound financial instruments with multiple embedded derivatives
  • Breaches of terms of loan agreements
  • Disclosures about de-recognitions

Statement of Comprehensive Income and Equity:

  • Items of income, expense, gains and losses
  • Interest income and interest expense for those financial instruments that are not measured at fair value through profit and loss
  • Fee income and expense
  • Amount of impairment losses on financial assets
  • Interest income on impaired financial assets

Other disclosures:

  • Accounting policies for financial instruments
  • Information about hedge accounting
  • Information about the fair values of each class of financial asset and financial liability, together with:
    • comparable carrying amounts
    • description of how fair value was determined
    • detailed information if fair value cannot be reliably measured

(Note that disclosure of fair values is not required when the carrying amount is a reasonable approximation of fair value, such as short term trade receivables and payables or for instruments whose fair value cannot be measured reliably).

Information About The Nature And Extent Of Risks Arising From Financial Instruments.

Qualitative disclosures: These describe:

  • risk exposures for each type of financial instrument
  • managements objectives, policies and processes for managing those risks
  • changes from the prior period

Quantitative disclosures:

The quantitative disclosures provide information about the extent to which the entity is exposed to risk, based on information provided internally to the entity’s key management personnel. These include:

  • summary quantitative data about exposure to each risk at the reporting date
  • disclosures about credit risk, liquidity risk and market risk
  • concentrations of risk

Credit Risk:

Includes:

  • maximum amount of exposure, description of collateral, information about credit quality of financial assets that are neither past due or impaired
  • for financial assets that are past due or impaired, analytical disclosures re required

Liquidity Risk:

Includes:

  • a maturity analysis of financial liabilities
  • description of approach to risk management

Market Risk:

This is the risk that the fair value or cash flows of a financial instrument will fluctuate due to changes in market prices. Market risk reflects interest rate risk, currency risk and other price risks.

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