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Financial instruments
Introduction
Broadly speaking, a "financial instrument" is a means of raising finance. In practice, the term covers a wide range of highly complex financial arrangements, but simple examples include loans of various types and share issues. There are three international standards which deal with financial instruments. These are: IAS32 Financial Instruments: Presentation IAS39 Financial Instruments: Recognition and Measurement IFRS7 Financial Instruments: Disclosures These standards define the term "financial instrument", identify several different types of financial instrument and prescribe the accounting treatment of each type. This area of accounting is renowned for its complexity and difficulty. In fact, the three standards listed above occupy nearly 450 pages of fine print. Accordingly, a detailed coverage of financial instruments is well beyond the scope of this book and the aim of this chapter is to provide only a basic introduction to the topic.
Objectives
By the end of this chapter, the reader should be able to; define the term "financial instrument" define the terms "financial asset", "financial liability" and "equity instrument" correctly classify financial instruments as either liabilities or equity explain the circumstances in which a financial asset or liability should be recognised calculate the amounts at which financial assets and financial liabilities should be measured on initial recognition and subsequently list the main disclosures required in relation to financial instruments.
Definitions
IAS32 Financial Instruments: Presentation provides four key definitions which apply throughout all of the standards which deal with financial instruments. The main features of these definitions are as follows: A financial instrument is "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity". A financial asset is "any asset that is: (a) cash; (b) an equity instrument of another entity; (c) a contractual right to receive cash or another financial asset from another entity". A financial liability is "any liability that is a contractual obligation to deliver cash or another financial asset to another entity". An equity instrument is "any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities". Ordinary shares are the most common instance of an equity instrument. The full definitions given in IAS32 are actually longer and more complex than this, but the versions given above are sufficient for most purposes. These definitions are illustrated in the following example. EXAMPLE 1
Explain why each of the transactions listed below gives rise to a financial instrument as defined by international standard IAS32: (a) (b) (c) (d) (e) (f) (g) a company makes an issue of loan stock a company sells goods to a customer on credit a company buys goods from a supplier on credit a company deposits money into its bank account a company overdraws its bank account a company makes an issue of ordinary shares a company invests in newly-issued ordinary shares of another company.
Solution
(a) The issue of loan stock creates a contractual obligation on the part of the company to repay the loan at some time in the future. The contract between the company and the lenders is a financial instrument because: - the lenders now have the right to be repaid (a financial asset) - the company is now under an obligation to repay the loan (a financial liability) 2
(b)
A sale on credit creates a contractual obligation on the part of the customer to pay for the goods. The contract with the customer is a financial instrument because: - the company now has a trade receivable (a financial asset) - the customer now has a trade payable (a financial liability).
(c)
A purchase on credit creates a contractual obligation on the part of the company to pay for the goods. The contract with the supplier is a financial instrument because: - the supplier now has a trade receivable (a financial asset) - the company now has a trade payable (a financial liability).
(d)
In effect, a bank deposit is a loan to the bank and the bank is contractually obliged to repay this money. The contract with the bank is a financial instrument because: - the company now has the right to withdraw its cash (a financial asset) - the bank is now under an obligation to repay the cash (a financial liability).
(e)
A bank overdraft is a form of bank loan and the company is contractually obliged to repay this loan. The contract with the bank is a financial instrument because: - the bank now has the right to be repaid (a financial asset) - the company is now under an obligation to repay the overdraft (a financial liability).
(f)
Ordinary shares are an equity instrument, as defined by IAS32. The issue of ordinary shares creates a contract between the company and its shareholders. This contract is a financial instrument because: - the shareholders now own the shares (a financial asset) - the company now has extra share capital (an equity instrument).
(g)
This purchase of ordinary shares creates a contract between the investing company and the issuing company. This contract is a financial instrument because: - the investing company now owns the shares (a financial asset) - the issuing company now has extra share capital (an equity instrument).
"the instrument includes no contractual obligation to deliver cash or another financial asset to another entity". Ordinary shares are an example of an equity instrument, since the company which issues the shares is under no contractual obligation to pay dividends and cannot legally repay the share capital. Ordinary shareholders may in fact receive dividends from time to time but the important point is that the company cannot be required to deliver cash or any other financial asset to these shareholders. This situation should be contrasted with a loan, where the borrower is generally obliged to make interest payments throughout the period of the loan and to repay the loan itself at the end of that period.
(a) The fair value of the liability component is determined first. This is equal to the fair value of a similar instrument without an associated equity component. The measurement rules of IAS39 indicate that this amount should be calculated by discounting the cash flows that the financial instrument generates, using a market rate of interest. (b) The fair value of the equity component is then determined by deducting the fair value of the liability component from the fair value of the whole instrument. IAS39 states that the fair value of the whole instrument is normally equal to the amount of the consideration which was given or received when the instrument was issued. As in several other standards, fair value is defined by IAS32 as "the amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arm's length transaction". EXAMPLE 2
On 1 January 2008, a company issues 200,000 of 7% loan stock at par. Interest on this loan stock is payable on 31 December each year. The stock is due for redemption at par on 31 December 2011 but may be converted into ordinary shares on that date instead. Assuming that the market rate of interest to be used in discounted cash flow calculations is 9% p.a., calculate the liability component and the equity component of this loan stock.
Solution
Ignoring the conversion option, the company will pay interest of 14,000 on 31 December 2008, 2009, 2010 and 2011 and will then make a 200,000 repayment of the loan stock on 31 December 2011. Using a discounting rate of 9%, the present value of these cash flows may be calculated as follows: Workings Payment due 31 December Payment due 31 December Payment due 31 December Payment due 31 December Total present value 2008 2009 2010 2011 14,000 1.09 14,000 (1.09)2 14,000 (1.09)3 214,000 (1.09)4 Present value 12,844 11,784 10,811 151,603 187,042
This calculation shows that the fair value on 1 January 2008 of the right to receive 14,000 on 31 December for each of the next three years, followed by 214,000 at the end of the fourth year is 187,042. This is the fair value of the liability component of the loan stock. The lenders are paying 200,000 to buy this stock and this exceeds the fair value of the liability component by 12,958. The extra 12,958 must be the price that the lenders are paying for the option to convert and this is the value of the equity component.
After initial recognition, financial assets which fall into this category should be measured at their fair value. Gains or losses arising from fluctuations in fair value are recognised in the income statement. (b) Held-to-maturity investments. These are financial assets with fixed or determinable payments and fixed maturity dates that the entity intends to hold until maturity and has the ability to do so. After initial recognition, held-to-maturity investments should be measured at their amortised cost using the effective interest method (see below). (c) Loans and receivables. These are financial assets with fixed or determinable payments that are not quoted in an active market. After initial recognition, loans and receivables should usually be measured at their amortised cost using the effective interest method. This method involves discounting the amounts expected to be received when the loan or the receivable is settled. But short-term receivables (e.g. most trade receivables) may be measured at the original invoice amount if the effect of discounting is not material. (d) Available-for-sale financial assets. These are financial assets which do not fall into any of the other three categories. An example of an available-for-sale financial asset is a long-term investment in ordinary shares. After initial recognition, available-for-sale financial assets should generally be measured at their fair value. Gains or losses arising from fluctuations in fair value are currently recognised in the statement of changes in equity. When the revised version of IAS1 takes effect (see Chapter 3) such gains and losses will be recognised in other comprehensive income. Note that it may sometimes be impossible to measure the fair value of unquoted ordinary shares reliably. In this case, such shares (which usually fall into category (d) above) should be measured at cost.
EXAMPLE 3
On 1 January 2008, a company buys 100,000 of 6% loan stock for 93,930. Interest will be received on 31 December each year and the stock will be redeemed at par on 31 December 2012. The company intends to hold the stock until maturity and calculates the effective interest rate to be 7.5% per annum. Financial statements are prepared to 31 December each year. (a) (b) (c) State the amount at which this loan stock should be measured on 1 January 2008. Calculate the amount at which the loan stock should be measured on 31 December 2008, 2009, 2010, 2011 and 2012. Show that the effective rate of 7.5% "exactly discounts estimated future cash receipts to the initial carrying amount of the asset" as required by IAS39.
Solution
(a) (b) The loan stock is measured initially at 93,930. The amortised cost of the loan stock at the end of each year is calculated as follows: Year Balance b/f 93,930 94,975 96,098 97,305 98,603 Interest @ 7.5% 7,045 7,123 7,207 7,298 7,397 36,070 Amount received (6,000) (6,000) (6,000) (6,000) (106,000) Amortised cost 94,975 96,098 97,305 98,603 0
Notes: (i) The interest earned each year is 7.5% of the balance brought forward. This is credited to the company's income statement. Interest at 7.5% for 2012 would in fact be 7,395 but this has been adjusted to 7,397 to ensure that the balance remaining at the end of the year is nil. It would appear that the effective rate of interest is actually very slightly more than 7.5%. The effective interest rate (7.5%) is higher than the rate (6%) at which annual interest payments are calculated because the company will receive a premium of 6,070 (100,000 - 93,930) when the loan stock is redeemed. The effective interest method spreads this premium fairly over the life of the loan stock.
(ii)
(iii) The total credit to the income statement is 36,070. This is equal to annual interest of 6,000 for five years plus the premium of 6,070.
(c)
If the amounts receivable during the life of the loan stock are discounted at an annual rate of 7.5%, the present value of each amount is as follows: Workings Receivable 31 December Receivable 31 December Receivable 31 December Receivable 31 December Receivable 31 December 2008 2009 2010 2011 2012 6,000 1.075 6,000 (1.075)2 6,000 (1.075)3 6,000 (1.075)4 106,000 (1.075)5 Present value
5,581 5,192 4,830 4,493 73,835 Total present value 93,931 Apart from a small rounding difference, an effective rate of 7.5% does indeed discount estimated future cash receipts to the initial carrying amount of 93,930.
(a) Financial liabilities at fair value through profit or loss. This category of financial liabilities is similar to the equivalent category of financial assets and consists mainly of financial liabilities that are held for trading. However, as with financial assets, an entity may designate any financial liability as being "at fair value through profit or loss" if doing so would result in more relevant information. After initial recognition, financial liabilities which fall into this category should be measured at fair value. Gains or losses arising from fluctuations in fair value should be recognised in the income statement. (b) Trade payables. Short-term payables (e.g. most trade payables) may be measured at the original invoice amount if the effect of discounting is not material. EXAMPLE 4
On 1 July 2008, a company issues 1million of 8% loan stock. The stock is issued at a 10% discount (so only 900,000 is received from the lenders) and issue costs of 39,300 are incurred. Interest is payable in arrears on 30 June each year and the loan stock is redeemable at par on 30 June 2011. The effective interest rate is calculated to be 14% per annum. The company prepares financial statements to 30 June each year. (a) (b) State the amount at which this loan stock should be measured on 1 July 2008. Calculate the amount at which the loan stock should be measured on 30 June 2009, 2010 and 2011.
Solution
(a) The loan stock should be measured initially at 860,700 (900,000 - 39,300). This is the amount of the consideration received when the stock was issued, less directly attributable transaction costs. The loan stock should be measured at amortised cost using the effective interest method. Amortised cost at the end of each year is calculated as follows: Year to 30 June 2009 2010 2011 Balance b/f 860,700 901,198 947,366 Interest @ 14% 120,498 126,168 132,634 379,300 Amount paid (80,000) (80,000) (1,080,000) Amortised cost 901,198 947,366 0
(b)
Notes: (i) The interest each year is 14% of the balance brought forward. This is charged to the company's income statement. Interest at 14% for 2011 is actually 132,631 but this has been adjusted to 132,634 to ensure that the balance remaining at
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the end of 2011 is nil. The effective rate of interest is in fact slightly more than 14%. (ii) The effective interest rate (14%) is higher than the rate (8%) at which annual interest payments are calculated because the loan was issued at a discount and the company has had to pay transaction costs. The effective interest method spreads these two items fairly over the life of the loan stock.
(iii) The total charge to the income statement is 379,300. This is equal to annual interest of 80,000 for three years plus the discount of 100,000 and issue costs of 39,300.
Disclosure requirements
International standard IFRS7 Financial Instruments: Disclosures requires entities to make a number of disclosures relating to financial instruments. The purpose of these disclosures is to enable users to evaluate two things. These are: (a) the significance of financial instruments for the financial position and financial performance of the entity concerned, and (b) the nature and extent of any risks to which the entity is exposed in relation to financial instruments, and the way in which those risks are being managed. These two matters are considered separately below.
(b) Allowance for credit losses. If financial assets are impaired by credit losses and the amount of the impairment is recorded in an allowance account (e.g. an allowance for
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doubtful debts) then the entity should disclose a reconciliation of changes in this allowance account during the accounting period for each class of financial assets. (c) Fair value. The fair value of each class of financial asset and liability should be disclosed in a way that facilitates comparison with carrying amounts. This disclosure is not required if fair value cannot be measured reliably (e.g. in the case of unquoted ordinary shares). (d) Items of income, expense, gains and losses. The entity should disclose the following items, either on the face of the financial statements or in the notes: (i) net gains or losses on each class of financial assets and liabilities (e.g. gains or losses arising from fair value fluctuations) (ii) total interest income and total interest expense for financial assets and liabilities measured at amortised cost (iii) the amount of any impairment loss for each class of financial asset. (e) Accounting policies. The entity should disclose the measurement bases and other accounting policies used in relation to financial instruments, where these are relevant to an understanding of the financial statements.
Specific detailed disclosures are also required in relation to credit risk, liquidity risk and market risk. The main disclosures are as follows:
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(a) Credit risk. For each class of financial asset, the entity should disclose: (i) (ii) (iii) (iv) the amount of the maximum exposure to credit risk an age analysis of financial assets that are overdue but not impaired an analysis of financial assets that are impaired a description of collateral held as security in respect of the amounts disclosed in (i), (ii) and (iii) above.
(b) Liquidity risk. The entity should disclose a maturity analysis for financial liabilities and a description of how any inherent liquidity risk is managed. (c) Market risk. The entity should disclose a sensitivity analysis for each type of market risk to which the entity is exposed. This analysis should show how profit or loss and equity would be affected by changes in the relevant risk variable (e.g. exchange rates or market interest rates).
Summary
A financial instrument is a contract which gives rise to a financial asset for one entity and a financial liability (or equity instrument) for another. Financial instruments are dealt with in international standards IAS32, IAS39 and IFRS7. IAS32 establishes rules for distinguishing between financial liabilities and equity instruments. The standard adopts a substance over form approach and states that an equity instrument is one which includes no contractual obligation to deliver cash (or any other financial asset) to another entity. Redeemable preference shares are generally classed as financial liabilities. Dividends relating to such shares are treated as an expense. A compound financial instrument is separated into its two components by evaluating the liability component first and then deducting this from the fair value of the whole instrument to give the equity component. Financial assets and liabilities are recognised when the relevant financial instrument becomes binding and are derecognised when the entity's contractual rights or obligations under the instrument cease. IAS39 requires that financial assets and liabilities are measured initially at fair value. Subsequent to initial recognition, financial assets at fair value through profit or loss and available-for-sale financial assets are measured at fair value. Held-to-maturity investments and loans and receivables are measured at amortised cost using the effective interest method.
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Subsequent to initial recognition, financial liabilities at fair value through profit or loss are measured at fair value. Most other financial liabilities are measured at amortised cost using the effective interest method. The disclosure requirements of IFRS7 enable users of the financial statements to evaluate the significance of an entity's financial instruments and the nature and extent of any risks to which the entity is exposed in relation to financial instruments.
Exercises
11.1 (a) (b) (c) Define the terms "financial instrument", "financial asset", "financial liability" and "equity instrument". Explain how international standard IAS32 distinguishes between financial liabilities and equity instruments. Explain the accounting treatment of redeemable preference shares required by IAS32. Explain what is meant by a "compound" financial instrument. Also explain the required accounting treatment of such an instrument. On 1 April 2008, a company issues a 500,000 4% convertible bond at par. Interest is payable on 31 March each year. The bond is redeemable at par on 31 March 2013 but may be converted into ordinary shares at any time before maturity. The market rate of interest to be used in discounting calculations is 6.5%. Calculate the liability component and the equity component of this bond. 11.3 (a) International standard IAS39 classifies financial assets into four categories. Identify and explain each of these categories. Also explain the way in which each category of financial asset should be measured subsequent to initial recognition. On 1 January 2008, a company which prepares financial statements to 30 June each year buys 400,000 of 5% loan notes for 411,225. Interest will be received halfyearly on 30 June and 31 December and the loan notes will be repaid at a premium of 10% on 31 December 2010. The effective rate of interest is 3.5% per half year and the company intends to hold this investment until maturity. Calculate the amount of interest income that should be credited to the company's income statement in each of the years to 30 June 2008, 2009, 2010 and 2011. Also calculate the amount at which the loan notes should be shown in the company's balance sheet at the end of each of these years. 11.4 (a) (b) Explain the terms "credit risk", "liquidity risk" and "market risk" which are used in international standard IFRS7. List the main disclosures required by IFRS7 in relation to each of these three types of risk.
11.2
(a) (b)
(b)
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*11.5
On 1 May 2008, a company which prepares financial statements to 30 April each year issues 750,000 of 3% loan stock at a discount of 5%. Issue costs are 13,175. Interest is payable on 30 April each year and the stock is redeemable on 30 April 2012 at a premium of 10%. The effective rate of interest is 7.25% per annum. (a) (b) State the amount at which the loan stock should be measured on 1 May 2008. Calculate the amount at which the loan stock should be shown in the company's balance sheet on 30 April 2009, 2010, 2011 and 2012.
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