Week 5 Everything Flashcards
Financial instruments
any contract that gives rise to both a financial
asset of one entity and a financial liability or equity
instrument of another entity”.
Fundamental characteristics of financial instruments:
Contract that establishes a right or an obligation.
“two sided”: one party of the contract must have a
financial asset, whilst the other party to the contract has responsibilities (obligations), so he/she will record either a financial liability or an equity instrument.
Financial Assets Definition [AASB132.11]
cash
equity instrument of another entity (shares of another company) (i.e. Investment in Company X)
contractual right
a contract that will or may be settled in the entity’s own equity instruments, both derivative and non-derivative
contractual right
To receive cash or another financial asset from another entity (e.g. trade receivable; debentures held).
To exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity (e.g. forward foreign currency contract – where the entity is a winning position)
Examples of financial assets
cash; trade accounts receivable; convertible notes receivable; loans receivable; bonds receivable; various derivatives, including forward foreign currency contracts
Financial assets ARE NOT
physical assets; leased assets or intangible assets
Financial Liabilities Definition [AASB132.11]
contractual obligation
a contract that will or may be settled in the entity’s own equity, both derivatives and non-derivatives (e.g. convertible note payable)
contractual obligation
to deliver cash or another financial asset to another entity (i.e. loan payable; trade payable)
to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity (e.g. forward foreign currency contract – where the entity is in a losing position)
Examples of financial liabilities:
trade accounts payable; convertible note payable; loans payable; bonds payable; various derivatives, including forward foreign currency contracts
Equity instruments
Any contract that evidences a RESIDUAL* interest in the asset of an entity after deducting all of its liabilities (i.e. ordinary shares in a company). BUT the contract DOES NOT INCLUDE an obligation:
Any contract that evidences a RESIDUAL* interest in the asset of an entity after deducting all of its liabilities (i.e. ordinary shares in a company). BUT the contract DOES NOT INCLUDE an obligation:
To deliver cash or another financial asset to another entity;
To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer
Examples of equity instruments
ordinary shares
Residual
Residual means that the holder of that equity instrument is NOT entitled to a fixed-rate of return (i.e. interest revenue)
When a company issues a financial instrument (i.e. bond; shares, etc.) the company is required to determine whether the financial instrument is to be reported as a
financial liability or an equity instrument.
Financial Liability:
If any interest, dividends, losses or gains arise, shall be recorded in Profit or Loss or Other Comprehensive Income
Equity instrument:
If any interest, dividends, losses or gains arise, shall be recorded in Changes in Equity
To decide, look at the SUBSTANCE of the contractual arrangement
(AASB132):
is there a contractual obligation to deliver cash or other financial assets?
YES Financial Liability
NO Equity instrument
Primary financial instruments:
Value of a primary financial instrument is determined in its own right, directly from the market. include trade receivables and payables; loans receivable and payable; and equity securities such as ordinary shares
Derivative financial instruments
Value of a derivative financial instrument is dependent upon the value of the underlying primary financial instrument (e.g. the value of BHP share options depends the value of BHP shares). Create rights and obligations with the effect of transferring one or more of the financial risks inherent in an underlying primary financial instrument (e.g. BHP share options transfer the risk of falls in fair value of BHP Shares from the option holder to the option issuer);
Examples of derivative financial instruments
options, futures, forward contracts and interest rate and currency swaps
Recognition of financial instruments
An entity may recognise a financial instrument in its statement of financial position ‘when the entity becomes party to the contractual provisions of the instruments’
Initial measurement of financial instruments
An entity shall measure a financial asset or liability at its fair value plus or minus the transaction costs that are directly attributable to the acquisition of the financial asset or the issue of the financial liability
Initial measurement of financial instruments equation
Fair value (+/- transaction costs)
Fair value
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
Subsequent measurement of financial instruments
After the initial recognition, two possible subsequent
measurements: amortised cost or fair value
Subsequent measurement of financial assets
After the initial recognition, the choice between amortised cost and fair value depends on how the financial assets are classified. Two elements to determine the classification, the entity’s business model and the contractual cash flow characteristics
The financial asset is measured at amortised cost if the financial asset has the two elements below
1) business model: The business usually holds financial assets in order to collect their contractual cash flows
cash flow characteristics: The financial asset gives rise
to cash flows on specified dates that represent only
payments of principal and interest on the principal
amount outstanding.
Where the business model or/and the cash flow characteristics
are different the financial asset is measured at
fair value
e.g. equity instruments are measured at fair value
Principal
Amount of money to be paid or received to enter the
contract (financial instrument) and the amount of money to be received or paid to extinguish that contract.
Principal example
Loan agreement between Bank and Company:
Company borrows an amount (principal) from Bank.
At the end of the loan: Company pays back the amount (principal).
Interest
A contractual amount to be paid (financial liability)
or to be received (financial asset) on specific dates during the duration of the contract (financial instrument).
Interest example
Interest on a loan issued by Bank to Company. Bank
receives interest revenues and Company pays interest expenses
Disclosure of risk requirements
Financial instruments are subject to extensive disclosure requirements (AASB 7), especially after significant losses in relation to financial instruments during GFC.
As a general principle, the company shall disclose:
information that enables users to evaluate the
significance of financial instruments for its financial
position and performance
Information that enables users to evaluate the nature and extent of risks arising from financial instruments
which the entity has at reporting date, and how the
entity manages those risks.
Disclosure of risk requirements
What are the risks to be disclosed?
Credit risk
Liquidity risk
Market risk
Credit risk
risk that a counterparty will default on its contractual obligations resulting in financial loss to the company
Liquidity risk
Risk that the company will not be able to meet its payment obligations associated with financial liabilities
Market risk
Risk that the fair value of a financial instrument will fluctuate due to changes in market prices. There are three types of market risk:
Currency risk
• Interest rate risk
• Other price risk
How are these risks disclosed?
- Qualitative disclosure
* Quantitative disclosure
