Financial Instruments PDF

DEPARTMENT OF ACCOUNTING, CORPORATE FINANCE AND TAXATION CHAPTER 7 FINANCIAL INSTRUMENTS Prof. Dr. Philippe Van Cauwenberge INTRODUCTION TO IAS 32, IFRS 7 AND IFRS 9 ̶ Very contentious standards, carve out from IAS 39 by the ARC in 2004, IAS 39 under pressure during the financial crisis in 2008...

DEPARTMENT OF ACCOUNTING, CORPORATE FINANCE AND TAXATION CHAPTER 7 FINANCIAL INSTRUMENTS Prof. Dr. Philippe Van Cauwenberge INTRODUCTION TO IAS 32, IFRS 7 AND IFRS 9 ̶ Very contentious standards, carve out from IAS 39 by the ARC in 2004, IAS 39 under pressure during the financial crisis in 2008 ̶ IAS 32 sets out the definitions of financial assets, liabilities and equity instruments ̶ IFRS 7 contains the disclosure requirements ̶ IFRS 9 includes procedures for the recognition and measurement of financial instruments WHAT IS A FINANCIAL INSTRUMENT? ̶ Financial Instrument: ‘... any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.’ ̶ Primary instruments:  Cash, receivables, shares, payables, bonds, loans ̶ Secondary (derivative) instruments:  Value is derived from underlying item: share price, interest rate, etc.  Financial options, forward exchange contracts COMMON FINANCIAL INSTRUMENTS FINANCIAL INSTRUMENTS - Contracts to buy/sell non-financial assets are not considered as a FI. - For instance, futures/options on a commodity like oil or copper. - However, such a contract is considered as a FI when monetary settlement is possible (and this is often the case) and when such instruments have markets for them. - Notice the potential treatment of preference shares as liabilities (study figure 7.2 on page 161) ! - Notice that derivatives can swap from an asset to a liability and vice versa ! DISTINGUISHING FINANCIAL LIABILITIES FROM EQUITY INSTRUMENTS ̶ Debt/equity distinctions are important – affects gearing and solvency ratios, debt covenants, treatment of payments as either interest or dividends & capital adequacy requirements (banks) ̶ A ‘substance over form’ test in IAS 32 aims to limit attraction to misclassify many as equity instruments (think about the preference shares) DISTINGUISHING FINANCIAL LIABILITIES FROM EQUITY INSTRUMENTS – SUBSTANCE OVER FORM TEST Equity instruments need to meet two conditions (A & B) ̶ Part A ‒ An equity instrument must include no contractual obligation to:  Deliver cash or other financial assets to another entity  Exchange assets/liabilities under conditions unfavourable to the issuer (complex transactions where holder of the instrument bears no equity risk)  Refer to Figure 7.2 pg 160 for application ̶ Part B – If the instrument will or may be settled in the issuer’s own equity instruments (pay with shares of the company itself)… DISTINGUISHING FINANCIAL LIABILITIES FROM EQUITY INSTRUMENTS – SUBSTANCE OVER FORM TEST … only considered as equity if it involves: I. a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments (see ex on page 162) (e.g. receive one million, pay back one million in shares) II. a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial assets for a fixed number of its own equity instruments (see ex page 162) (issue call to buy shares at variable price) COMPOUND FINANCIAL INSTRUMENTS ̶Compound financial instruments contain both a liability and an equity component ̶IAS 32 prescribes that the financial liability must be calculated first, with the equity component by definition being the residual ̶This equity component is NOT remeasured (because it is classified as equity).  Refer to Figure 7.3 p 163 INTEREST, DIVIDENDS, GAINS AND LOSSES SCOPE OF IFRS 9 ̶Stated objective to establish principles. ̶Arguably it establishes rules rather than principles ̶A very complex standard that applies to all entities and to all types of financial instruments, with 11 exceptions (e.g. Investments in subs., associates and joint ventures, except in separate financial statements, rights and obligations under leases, IAS 19 (employee benefits), IFRS 2, Share-based payments, …) ̶ Under IFRS 9, investments in subsidiaries are generally not in the scope of IFRS 9 because they are governed by IFRS 10 (Consolidated Financial Statements) instead. IFRS 10 requires that if an investor controls an investee (subsidiary), the investor must consolidate the subsidiary’s financial statements, rather than apply financial instrument accounting. This means the subsidiary’s individual assets, liabilities, income, and expenses are combined line-by-line with those of the parent company, and intercompany balances are eliminated in consolidation. ̶ However, IFRS 9 comes into play in the separate Financial Statements: If a parent company presents separate (non-consolidated) financial statements, then IFRS 9 may apply to the investment in the subsidiary, unless the company opts to measure the investment at cost or at fair value under IFRS standards. 1. Cost Model: Investments are carried at cost, less any impairment. 2. Fair Value Model: Investments are measured at fair value, with changes in fair value recognized either through profit or loss or other comprehensive income (OCI), depending on the company's choice and classification under IFRS 9. DERIVATIVES AND EMBEDDED DERIVATIVES ̶ Defined in IFRS 9  An instrument whose value is derived from underlying item: share price, interest rate, etc. ̶ Derivatives must meet the following three characteristics: 1. Its value must change in response to (be ‘derived’ from) the change in a specified variable 2. Requires no/minimal net investment 3. Settled at some time in the future ̶ Include futures, forward, swap and option contracts ̶ May be stand-alone or embedded in a compound (hybrid) instrument (e.g. convertible option) EXAMPLES OF DERIVATIVES ̶ Interest Rate Swaps and Forward Rate Agreements: Contracts to exchange cash flows as of a specified date or a series of specified dates based on a notional amount and fixed and floating rates (e.g. LIBOR, EURIBOR). ̶ Forwards: Contracts to purchase or sell a specific quantity of a financial instrument, a commodity, or a foreign currency at a specified price determined at the outset, with delivery or settlement at a specified future date ̶ Futures: Contracts similar to forwards but futures are generic exchange-traded, whereas forwards are individually tailored. ̶ Options: Contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specified quantity of a particular financial instrument, commodity, or foreign currency, at a specified price (strike price), during or at a specified period of time. These can be individually written or exchange- traded. The purchaser of the option pays the seller (writer) of the option a fee (premium) to compensate the seller for the risk of payments under the option. A WORD ABOUT OPTIONS ̶ An option is a contract that gives the holder a right to buy (call) or sell (put) an underlying asset (share, commodity, …) during a certain period at a certain price (the strike price). The writer of the option has granted this right and normally receives a premium for writing the option. ̶ Once an option is created, it can be traded by the holder. There are markets and market prices for options. ̶ The right to buy or sell does not exist infinitely (expiry date) ̶ The holder has a right to buy of sell the underlying(execute), there is no obligation to execute like with a futures contract. ̶ An option can be in the money, out of the money or at the money. In the money means that execution of the option is profitable (market price underlying > strike price for a call, market price underlying < strike price for a put). ̶ The value of an option is composed of intrinsic value and time value ̶ For a call, IV = max (price underlying – strike price, 0), for a put IV = max (strike price – market price underlying, 0) ̶ The time value is the value of the probability that the IV might increase before the expiration date. ̶ The time value is determined by 1) the volatility of the underlying, 2) the interest rate 3) the dividend of the underlying 4) the market expectation concerning the underlying 5) the time to expiration Examples: ̶ CASE 1 : strike call = 80, share price = 90, then IV = 10 ̶ CASE 2 : Strike call = 80, share price = 75, then IV = 0 ̶ Suppose that in CASE 1, the market value of the option is 15, then we can infer that the time value (TV) impliciet in the options market = 5 (i.e. 15 – 10) ̶ Strike put = 80, share price = 75, then IV = 5 ̶ Strike put = 80 and share price = 70, then IV = 10. ̶ The IV of a put option moves in opposite direction with the price of the underlying. ̶ Use of options: ̶ Speculative: 1) buy calls or puts without a position in the underlying, 2) write naked calls or puts ̶ Protective: insure a share portfolio with puts ̶ As an alternative to an automatic share selling order: write a call with the same strike price as the price in the automatic order (= covered call) OPTIONS ARE VOLATILE ̶ Say price call = 4, strike 98, price underlying = 100, one month before expiration. ̶ TV hence equals 4 – 2 (IV = 100-98) = 2 ̶ Imagine a small price increase of share with 4% to 104, ceteris paribus ̶ Price call = IV (6 = 104-98) + TV ( = 2 , ceteris paribus) = 8 ̶ In other words, the share increase with 4% has generated an increase of the option price with 100% ̶ Imagine a price decrease with 2% => ceteris paribus, return call = -50% MEASUREMENT CATEGORIES FOR FINANCIAL ASSETS ̶ IFRS 9 has the following measurement categories for financial assets: see table 7.3 pg 169!  Debt instruments at amortised cost.  Debt instruments at fair value through other comprehensive income (FVOCI) with cumulative gains and losses reclassified to profit or loss upon derecognition.  Equity instruments designated as measured at FVOCI with gains and losses remaining in other comprehensive income (OCI) without subsequent reclassification to profit or loss.  Debt instruments, derivatives and equity instruments at fair value through profit or loss (FVPL). MEASUREMENT CATEGORIES FOR FINANCIAL ASSETS CASH FLOW CHARACTERISTICS ̶ Is done at the individual asset level ̶ Are the cash flows solely payments of principal and interest?(SPPI) ̶ The purpose is the check whether the application of the effective interest method is viable from a mechanical point of view? ̶ Not when value or cash flows of a debt instrument are, for instance, related to a commodity price BUSINESS MODELS ̶The business model assessment is not made on the instrument level but at a higher level of aggregation 3 possibilities:  Hold to collect: objective is to collect contractual cash flows  Hold to collect and sell: both collecting contractual cash flows and selling are an objective (e.g. to manage liquidity needs)  Held for trading or managed on a fair value basis MEASUREMENT CATEGORIES FOR FINANCIAL LIABILITIES ̶IFRS 9 has the following measurement categories for financial liabilities:  Financial liabilities at amortised cost.  Financial liabilities at fair value through profit or loss. MEASUREMENT CATEGORIES FOR FINANCIAL LIABILITIES Designation ? For instance, a company may issue debt and enter into a derivative instrument (like an interest rate swap) to hedge the debt’s interest rate risk. Designating the debt at fair value aligns the accounting treatment of the debt with the hedge, simplifying performance reporting. MEASUREMENT CATEGORIES FOR FINANCIAL LIABILITIES ! For financial liabilities that are designated at FVPL  The element of gains/losses attributible to changes in the entity’s own credit risk is recognised in OCI. RECOGNITION CRITERIA AND MEASUREMENT ̶A financial asset or liability is recognised when the entity becomes a party to the contractual provisions of the instrument MEASUREMENT ̶ Initial recognition = fair value + (Asset) /- (Liability) transaction costs ! (except for FA & FL measured at FV through profit and loss) ̶ Fair Value : price that would be received to sell an asset or paid to transfer a liability (= exit concept) ̶ Transaction costs include:  Fees and commissions  Levies by regulatory agencies and securities exchanges  Taxes and duties ̶ Transaction costs do not include:  Financing costs  Internal administrative costs FAIR VALUE OF FI ̶FV is normally the transaction price ̶However, if the consideration given or received is for something other than the financial instrument, then the fair value must be estimated using valuation techniques ̶See ex on page 172 SUBSEQUENT MEASUREMENT ̶ Depends on whether the item is an asset or liability and on which of the categories applies ̶ Assets:  At amortised cost: o debt instruments measured at amortised cost  At fair value: o Debt instruments at FV through OCI o Equity instruments at FV through OCI o Debt instruments, equity instruments and derivatives at FV through P/L AMORTISED COST METHOD ̶ AC = The amount at which the FI is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortisation using the effective interest method (EIM). ̶ EIM = ̶ calculates the amortised cost of a FI and ̶ allocates interest revenue or expense in P/L over the relevant period. ̶ The effective interest = the rate that exactly discounts estimated future cash flows of a FI to the gross carrying amount of the FI (which is the amortised cost) ̶ See pg. 172, DETERMINE THE EFFECIVE INTEREST FOREXAMPLE 7.1 AND 7.2 ̶ The effective interest for example 7.1 is the i that satisties 1.000 = 59/(1+i) + 59/(1+i)² + … + (59+1.250)/(1+i)5 ̶ For example 7.2, the effective interest is that i that safisfies 975.000 = 50.000/(1+i) + 50.000/(1+i)² + 70.000/(1+i)3 + (70.000+1.000.000)/(1+i)4 A WORD ON THE AMORTIZED COST ̶ Remember that the effective interest is the interest that equates the present value of the cash flows of a financial instrument. ̶ Start from a base situation where a financial instrument, say a bond, is issued at par (100 EUR) and the contractual interest i = 0,05, and the time to maturity is 1 year. ̶ In that case, obviously, the eir (effective interest rate) will be 5% since 100 = (100+5)/(1+0,05) ̶ Now introduce transaction costs, say of 3 EUR, then, if the bond is an asset, the eir will reduce to 1,94% since 100+3 = (100+5)/(1 + 0,0194). Intuitively, for the holder, the transaction costs reduce the effective interest) - Suppose again transaction cost of 3 EUR, if the bond is a liability, then the eir increase to 8,25% since 100 – 3 = (100+5)/1+ 0,0825). Intuitively, the transaction costs increase the effective cost of the debt. - Returning to the base situation, but now introducing disagio of say 10, then the effective interest will, both for the lender and the creditor, increase to 16,67 % since 100 – 10 = (100+5)/(1+0,1667). Intuitively, not only the contractual interest, but also the disagio is part of the return (or cost) of the financial instrument ̶Liabilities:  Measured at amortised cost except for those that meet the definition of for trading and those designated at FV through P/L.  See pg. 174 GAINS AND LOSSES G/L of FI at FV is recognised in P/L unless:  It is part of a hedge relationship  It is an investment in an equity instrument for which G/L are recognised in OCI  It is a debt instrument at FV through OCI  It is a financial liability for which the entity is required to present the effects in own credit risk in OCI IMPAIRMENT AND UNCOLLECTABILITY THE FORWARD LOOKING EXPECTED CREDIT LOSS MODEL OPERATIONAL SIMPLIFICATIONS TO ASSESS CREDIT RISK ̶If a FI has low credit risk (=investment grade, AAA, AA, A, BBB), then the entity may assume that no significant changes in credit risk have occurred ̶If forward-looking info is not available, there is an assumption that credit risk has increased when contractual payments are over more than 30 days due PURCHASED OR ORIGINATED CREDIT- IMPAIRED FINANCIAL ASSETS ̶The general approach does not apply. ̶Instead: the expected credit loss would be reflected in a higher credit-adjusted effective interest rate. ̶Only recognise impairment gain or loss for changes in lifetime expected credit loss MEASUREMENT OF EXPECTED CREDIT LOSSES ̶ Lifetime expected credit losses should be estimated on the PV of all cash shortfalls over the remaining life of the instrument ̶ The 12-month expected credit losses are also based on the present value of cash shortfalls over the remaining life of the financial instrument, but only take into account the shortfalls resulting from default events that are expected to occur within the 12 months after the reporting date. ̶ Period: consider the maximum contractual period ̶ Use probability-weighted outcomes ̶ Interest rate: Discount credit losses with the effective interest rate that is determined at initial recognition (otherwise one equation with two unknowns, and otherwise one would adjust two times negatively : A) with the lower expected value of predicted cash flows and B) with a higher interest rate used to discount) The impairment rules do NOT apply to  Equity instruments designated as measured at FV through OCI !!!  Derivatives, debt and equity instruments at FV through P/L RECOGNITION OF IMPAIRMENT LOSSES ̶Debt instruments measured at AC: recognize loss allowance in statement of financial position and P/L ̶Debt instruments measured at FV through OCI: recognize the loss in OCI and not reduce the carrying amount of the financial asset in the financial position. ̶So the impairment loss in shown in P/L as a clear warning sign ̶THERE IS NO IMPAIRMENT FOR SHARES (BOOKED AT FV WITH G/L in OCI)! ̶Examples 7.3 and 7.4 pg. 178-79 (altijd +8 in pdf) HEDGE ACCOUNTING ̶Hedge arrangements are entered into to protect an entity from risk – e.g. currency or interest rate risk ̶Hedge accounting generally results in a closer matching of the statement of financial position effect with the profit or loss effect ̶Protects the statement of profit or loss and other comprehensive income from volatility caused by fair value changes over time HEDGE ACCOUNTING - DEFINITIONS ̶ Hedging instrument  A hedging instrument is a financial asset or financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item  Eight essential criteria for an instrument to be classified as a hedging instrument (pg 182) ̶ Hedged item  A hedged item is an asset, liability, anticipated transaction, unrecognised firm commitment or net investment in a foreign operation that:  Exposes the entity to risk of changes in fair value or future cash flows and  Is designated as being hedged HEDGE ACCOUNTING - CONDITIONS ̶Three conditions must be met in order for hedge accounting to be applied: 1. Must be formal designation and documentation of the hedge at inception 2. The hedging relationship consists only of eligible hedging instruments and eligible hedged items 3. The hedging relationship should meet hedge effectiveness requirements HEDGE ACCOUNTING – TYPES OF HEDGES ̶ Fair value hedge  A hedge of the exposure to changes in the FV of an asset, liability or unrecognized firm commitment ̶ Cash flow hedge  A hedge of the exposure to the variability in cash flows of a recognised asset or liability or forecasted transaction  Locks in future cash flows ̶ Hedge of a net investment in a foreign operation  Accounting treatment is similar to the accounting treatment of cash flow hedge CASH FLOW HEDGE  HEDGE ACCOUNTING Summary of hedge accounting: table 7,6 ̶ But basically, remember the following Fair value hedge accounting ̶ Risk : Fair value risk of a hedged item (recognised asset/liability (e.g. bond with fixed interest rate) or unrecognized firm commitment) ̶ Measure hedging instrument (derivate) at FV with G/L in P/L  Measure hedged item at FV with G/L in P/L although IFRS 9 might command differently ̶ Exception: when the hedged item is an equity instrument measured at FV with G/L in OCI, then record G/L on the derivative in OCI. No recycling. Cash flow hedge accounting - Risk : Cash flow risk of a hedged item: recognised A/L (e.g. bond with variable interest) or probable transaction  Measure derivative at FV but record G/L in OCI - When cash flows from recognised A/L or probable transaction are recorded in P/L, recycle accumulated amount of G/L on derivative from OCI to P/L WNTS ̶ Page 159: definitions of financial assets and liabilities (only look at the table) ̶ Page 161: From ‘Another example of…’ to the start of part (b) on page 162 ̶ 7.4.2 ̶ 7.7 ̶ 7.8.3 ̶ 7.10 ̶ Pg. 174: There are four exceptions to this rule‘ ̶ 7.11.3 ̶ 7.12 ̶ Pg. 186: From: ‘If this transaction…’ ̶ 7.13.4 ̶ 7.13.5 ̶ 7.14 Prof. Philippe Van Cauwenberge DEPARTMENT OF ACCOUNTING, CORPORATE FINANCE AND TAXATION (EB22) E [email protected] T +32 9 264 35 35 www.ugent.be 47