Chapter 7 Financial Instruments Flashcards
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
- cash
- an equity instrument of another entity
- a contractual right:
(i) to receive cash or another financial asset from another entity or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity - a contract that will or may be settled in the entity’s own equity instruments.
e.g. Trade receivables, options, shares (investment)
Financial liability
Any liability that is:
- a contractual obligation:
(i) to deliver cash or another financial asset to another entity or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity or - a contract that will or may be settled in an entity’s own equity instruments
e. g. Trade payables, debenture loans (payable), mandatorily redeemable preference shares, forward contracts standing at a loss.
Equity instrument
Any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities.
e.g. Own ordinary shares, warrants, non-cumulative irredeemable preference shares.
Derivative
A derivative has three characteristics
- it’s value changes in response to an underlying variable
- it requires little or no initial net investment
- it is settled at a future date
Compound instruments
Where a financial instrument contains equity and some of financial liability then its separate components need to be classified separately.
Method
1. Determine the carrying amount of the liability component (measure the fair value of a similar liability that does not have an associated equity component).
- Assign the residual amount to the equity component.
Recognition (IFRS 9)
Financial assets and liabilities are recognised in the statement of financial position when the entity becomes a party to the contractual provisions of the instrument.
Contracts entered into (and continue to be held) for the entity’s expected purchase, sale or usage requirements of non-financial items are outside the scope of IFRS 9.
Derecognition (IFRS 9)
Derecognition happens:
Financial assets:
When the contractual rights to the cash flows expire or the financial asset is transferred based on whether the entity has transferred substantially all the risks and rewards of ownership of the financial asset.
Financial liabilities:
When the obligation is discharged, cancelled or expires.
Measurement (IFRS 9) Financial assets
- Investments in debt instruments
- held to collect contractual cash flows and cash flows are solely principal and interest
Initial measurement:
Fair value and transaction costs
Subsequent measurement:
Amortised cost
- held to collect contractual cash flows and to sell and cash flows are solely principal and interest
Initial measurement:
Fair value and transaction costs
Subsequent measurement:
Fair value through other comprehensive income (with reclassification to p/l on derecognition)
N.B. Interest revenue calculated on amortised cost basis recognised in p/l
- Investments in equity instruments not held for trading
Initial measurement:
Fair value and transaction costs
Subsequent measurement:
Fair value through other comprehensive income (no reclassification to p/l on derecognition)
N.B. Dividend income recognised in p/l
- All other financial assets
Initial measurement: Fair value (transaction costs expensed in p/l)
Subsequent measurement:
Fair value through profit or loss
Treatment of gain or loss on derecognition
- On derecognition of a financial asset in its entirety, the difference between:
(i) the carrying amount (measured at date of recognition)
(ii) the consideration received
is recognised in profit or loss.
- In the case of investments in equity instruments not held for trading where the irrevocable election has been made, all changes in fair value are reported in other comprehensive income.
Therefore a gain or loss in profit or loss will only arise if the investments in equity instruments are not sold at their fair value and for any transaction costs on derecognition.
- For investments in debt held at fair value through other comprehensive income, the cumulative revaluation gain or loss previously recognised in other comprehensive income is reclassified to profit or loss.
Measurement (IFRS 9) Financial liabilities
- Most financial liabilities
Initial measurement:
Fair value less transaction costs
Subsequent measurement:
Amortised cost
- Financial liabilities at fair value through profit or loss
Initial measurement: Fair value (transaction costs expensed in p/l)
Subsequent measurement:
Fair value through profit or loss
- Financial liabilities arising when transfer of financial asset does not qualify for derecognition
Initial measurement:
Consideration received
Subsequent measurement:
Measure financial liability on same basis as transferred asset
- Financial guarantee contracts and commitments to provide a loan at a below market interest rate
Initial measurement:
Fair value less transaction costs
Subsequent measurement:
Higher of:
- impairment less allowance
- amount initially recognised less amounts amortised to p/l (IFRS 15)
Embedded derivatives (IFRS 9)
IFRS 9 requires embedded derivatives to be separated from the host contract unless:
(i) the economic characteristics and risks of the embedded derivative are closely related to those of the host contract or
(ii) the hybrid (combined) instrument is measured at fair value through profit or loss or
(iii) the host contract is a financial asset within the scope of IFRS 9 or
(iv) the embedded derivative significantly modifies the cash flows of the contract.
Impairment of financial assets (IFRS 9)
Credit losses should be recognised in 3 stages:
Stage 1:
Initial recognition
Credit losses recognised: 12 month expected credit losses
Calculation of effective interest: on gross carrying amount
Stage 2:
Credit risk increases significantly
Credit losses recognised: lifetime expected credit losses
Calculation of effective interest: on gross carrying amount
Stage 3:
Objective evidence of impairment exists at the reporting date
Credit losses recognised: lifetime expected credit losses
Calculation of effective interest: on carrying amount net of allowance for credit losses after date evidence exists
Presentation
With exception of investments in debt instruments measured at fair value through OCI, credit losses are recognised in profit or loss and held in a separate allowance account which is offset against the carrying amount of the asset.
For investments in debt measured at fair value through OCI, the portion in the fall in fair value relating to credit losses should be recognised in profit or loss with the remainder recognised in other comprehensive income.
Hedging (IFRS 9)
- Fair value hedges
These hedge the change in value of a recognised asset or liability that could affect profit or loss.
All gains and losses on both the hedged item and hedging instrument are recognised immediately in profit or loss. The gain or loss on the hedged item adjusts the carrying amount of hedged item.
If the hedged item is an investment in an equity instrument held at fair value through other comprehensive income, the gains and losses on both will be recognised in other comprehensive income.
- Cash flow hedges
These hedge the risk of change in value of future cash flows from a recognised asset or liability (or highly probable forecast transaction) that could affect profit or loss and is accounted for as follows:-
- the portion of the gain or loss on the hedging instrument effective is recognised in other comprehensive income and the cash flow hedge reserve
- any excess is recognised immediately to profit or loss
The amount that has been accumulated in the cash flow hedge reserve is then accounted for as follows:
- if results in the recognition of a non-financial asset or non-financial liability, the amount shall be removed from the cash flow reserve and included directly in the initial cost or carrying amount of the asset or liability
- for all other cash flow hedges, the amount is reclassified from other comprehensive income to profit or loss in the same period the hedged expected future cash flows affect profit or loss
