Tutorial 9- ACW 3491 Financial Instruments

Relevant Standards:

1. AASB 7 Financial Instruments: Disclosure

2. AASB 132 Financial Instruments: Presentation (Definition of
financial instruments etc)
3. AASB 139 Financial Instruments: Recognition & Measurement
(Categories)

NOTES:

Financial Instrument any contract giving rise to both

financial asset in one entity and financial liability/ equity
instrument of another entity.

Financial Asset Financial Liability Equity Instrument

- Cash - Contractual Obligation Any contract providing
- Contractual right to: to: holder with residual
i) Receive cash/another interest in assets of
financial asset i) Deliver cash/ another another company after
financial asset deduction of all its
ii) Exchange financial liabilities
instruments under
potentially favourable ii) Exchange financial Fin instrument equity
conditions instruments under (AASB 132)
potentially No potentially
unfavourable unfavourable
conditions contractual
obligations
Potential for
residual risk
present.
- An equity instrument of - A contract that is E.g. Ordinary Shares
another entity : derivative or non-
derivatives or non- derivative
derivatives
Categories of Financial Instruments (AASB 139) Past but MUST
KNOW

Categories of Financial Instruments (AASB 9)

1. At fair value
2. Amortised Cost

AASB 9 recognition of financial instrument when entity becomes party

to contractual provisions of instrument. (Generally measured at fair
value).

AASB 13 Fair Value Price that would be received to sell an asset or

paid to transfer a liability in an orderly transaction between market
participants on measurement date.

Financial asset

Initial recognition @ Fair value Subsequent @ FV or Amortised cost.

Use of FV or Amortised cost dependent on:

i) Entitys business model for managing financial asset
ii) Contractual CF characteristics of financial asset.
Fair value if to realize fair value changes
 Amortised cost if to receive periodic interest payments &
principal repayment.
Held for trading* at fair value because NOT held to collect
contractual cash flows (example of substance over form).

Financial liabilities

Subsequent measurement ALL amortised cost @ effective

interest method.

Derivatives

Creates rights and obligations with effect of transferring one/more

financial risks inherent in underlying primary financial instrument
to shift underlying risk and benefit.
Derivative characteristics (AASB 139):
Value changes in response to change in specified interest rate,
financial instrument price, commodity price, forex rate, index of
prices or rates, credit rating/ credit index, or other variable (the
underlying)
Requires no initial net investment or initial net investment that is
smaller than required for other types of contracts that would be
expected to have similar response to changes in market factors;
Settled at future date

Hedging (AASB 139)

Hedge contract Arrangement with another party, in which that party

accepts risks associated with changing commodity prices or exchange rates

Cash-flow hedge (hedge future expected cash flows) the gain or

loss on the hedging instrument (for example, a futures contract) is
initially recorded in equity.
It can subsequently (following date of acquisition) to profit and loss
so as to offset the impact on profit or loss of any change in value of the
hedged item (for example, an amount owing to an overseas supplier).
 For purchase of inventory, purchase not recognised until shipped
Fair value hedge (hedge value of A/L) the change in value of the
hedged item and the change in value of the hedging instrument are
both immediately in profit or loss.

Preference shares/ Convertible bonds, notes)- AASB 132

1. Preference Shares/ Debt
Liability Option of mandatory redemption for preference
shares
If debt, period payments = interest expenses impact profits.
Equity Risk and reward at entitys (issuer) discretion

2. Convertible notes/bonds (Compound instrument: Residual

approach )
Holder has right to: Securities Ordinary shares
Double entry must segregate liability and equity component
Interest CAN be part of Asset under Construction.
Interest expense must be segregated into cash and liability
portion.
 Extra Info
Mark to market = denoting or relating to a system of valuing
assets by the most recent market price.
Swap: No need table
Entity ultimately paying fixed interest and principal will be
the one with foreign loan. Other entity will have to top up/
receive difference.
Forward contract: Need table to compute net gain.
If have foreign payable, in forward agreement, the payable
part will be fixed.
Same for receivable.

Tutorial
3. What is a derivative financial instrument? Provide some
examples.

Derivative Financial Instruments:

Instruments which create rights and obligations that have the

effect of transferring one or more of the financial risks
inherent in an underlying primary financial instrument; and
The value of the contract normally reflects changes in the
value of the underlying financial instrument (International
Accounting Standards Committee, Exposure Draft 40: Financial
Instruments). This is consistent with the description provided at
paragraph AG 16 of AASB 132 which states:

Derivative financial instruments create rights and

obligations that have the effect of transferring between the
parties to the instrument one or more of the financial risks
inherent in an underlying primary financial instrument.

On inception, derivative financial instruments give one party a

contractual right to exchange financial assets or financial
liabilities with another party under conditions that are potentially
favourable, or a contractual obligation to exchange financial
assets or financial liabilities with another party under conditions
that are potentially unfavourable.

However, they generally do not result in a transfer of the

underlying primary financial instrument on inception of the
contract, nor does such a transfer necessarily take place on
maturity of the contract.

Some instruments embody both a right and an obligation to

make an exchange.

Because the terms of the exchange are determined on inception

of the derivative instrument, as prices in financial markets
change, those terms may become either favourable or
unfavourable.

Derivative financial instruments would include financial options,

futures, forward contracts and interest rate or currency swaps.
4. What factors influence the value of a derivative financial
instrument, and how should changes in the value of derivatives be
treated from an accounting perspective?

The value of a derivative is directly related to another

underlying item.
For example, a share option - which is a derivative - derives its value
from the market value of the underlying shares.
Derivative financial instruments create rights and obligations that have
the effect of transferring one or more of the financial risks inherent in
the underlying primary financial instrument.
According to paragraph 9(a) of AASB 139, the value of a derivative:

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,
provided in the case of a non-financial variable that the variable is not
specific to a party to the contract (sometimes called the underlying);

In relation to the measurement of derivative financial instruments

there is a general requirement, as provided in AASB 139, that
financial instruments are to be measured at fair value.
As with financial instruments generally, all derivatives are required to
be recognised and measured at fair value. Gains and losses on the
financial instruments would generally go directly to the profit and loss
account.
However, this will be influenced by whether there is an associated
hedge that has been designated as a hedge and that has been deemed
to be effective.
Where there is a designated cash-flow hedge, the gain or loss
on the hedging instrument (for example, a futures contract) is
initially recorded in equity.
It can subsequently be transferred to profit and loss so as
to offset the impact on profit or loss of any change in value of
the hedged item (for example, an amount owing to an overseas
supplier).
 Where an item is designated a fair value hedge (usually one-
off), the change in value of the hedged item and the change in
value of the hedging instrument are both immediately
recognised in profit or loss.

8. What is a compound financial instrument? Provide some answers.

COMPOUND INSTRUMENTS

Contains both a financial liability and equity component

There is a requirement that the debt and equity components of a

compound instrument be accounted for separately.

Includes convertible notes Similar to convertible bonds, except less

formal in the absence of a detailed deed

AASB 132: Requires equity component = FV of the whole instrument -

FV of the liability component Equity component is the residual
measure (see notes above)

AASB Framework considers perceived probabilities of conversion

Differently from AASB 132

12. When does right of set-off exist?

AASB 132 allows assets and liabilities to be set-off for statement of financial
position purposes when:

A legally recognised right of set-off exists, and;

The entities expect to settle the debts on a net basis.

Specifically, paragraph 42 of AASB 132 states:

A financial asset and a financial liability shall be offset and the net amount
presented in the statement of financial position when, and only when, an
entity:
(a) currently has a legally enforceable right to set off the recognised
amounts; and

(b) intends either to settle on a net basis, or to realise the asset and
settle the liability simultaneously.

19. Explain how a currency swap operates.

Swaps occur when borrowers exchange aspects of their respective

loan obligations. Foreign currency swaps occur when the obligation
related to a loan denominated in one currency is swapped for a loan
denominated in another currency.
If an organisation has receivables and payables that are both
denominated in another particular foreign currency, then changes in
the spot rates will create gains on one, but losses on the other.
To the extent that the receivable and payables are for the same
amount and denominated in the same currency, the losses on one
monetary item (perhaps the foreign currency payable) will be offset by
gains on the other monetary item (perhaps the foreign currency
receivable).
If a particular organisation has a number of receivables that are
denominated in a foreign currency then changes in spot rates may
potentially create sizeable foreign currency gains, or sizeable foreign
currency losses.
If that same organisation does not have any payables denominated in
the same currency then it will be exposed to potential gains and losses.
If it is able to convert some of its domestic loans into foreign currency
loans, of the same denomination as its receivables, then it will be able
to effectively insulate or hedge itself from the effects of changes in
spot rates.
A gain on one will effectively offset the loss on the other.
Such an organisation may seek to find another entity that is prepared
to swap its foreign currency loans for the organisations domestic
loans.
20. Explain how an interest rate swap operates.

When an interest rate swap occurs, one party exchanges its interest
payments of a specified amount with another party.
This generally involves swapping one stream of interest payments
which are charged at a variable or floating rate with another stream
of interest payments which are of a fixed amount.
For a swap to proceed, both parties to the swap will need to receive
benefits in the form of reductions in total interest payments.
They will be able to achieve savings in interest expenses and be able
to obtain their preferred terms, for example, a fixed interest obligation
or a variable interest obligation.

22. Where are the gains and losses on a futures contract reported?
Is the reporting of the gains/losses on a futures contract influenced
by whether or not the contract is used as part of a hedging
instrument?

The gains or losses on a futures contract would be taken to profit or

loss as they occur.
Exception:
i. If the futures are used as part of a hedging arrangement; and
ii. the hedging arrangement is deemed to be both effective; and
iii. To be a cash-flow hedge (in which case the gain or loss on the
hedging instrument can be taken initially to equity if it is a cash-
flow hedge and then transferred to profit or loss to counter the
gain or loss made on the hedged item).

Three types of hedges are identified in paragraph 86 of AASB 139:

o fair value hedges
o cash-flow hedges
o hedges of net investments in foreign operations
 For a fair value hedge:
o the hedging instrument (for example, a futures contract)
would be measured at fair value with changes going to profit or
loss.
o The hedged item, which might for instance be a share portfolio,
would also be valued at fair value with changes also going to
profit or loss.
Exception:
o Where the entity, at its own option, designates an arrangement
as a cash-flow hedge.
o For hedge accounting to be allowed, and for the gain or loss to
be included in equity, the hedge must be deemed to be
effective. If a cash-flow hedge is not deemed to be effective
then the gain or loss on the hedging instrument goes
immediately to profit or loss.

For a cash-flow hedge (Paragraph 86 of AASB 139):

o Gain or loss on the hedging instrument to be transferred initially
to equity and subsequently to profit or loss to offset the
gains or losses on the hedged item.
o This can be contrasted with a fair value hedge, where the gains
or losses on the hedging instrument are to be transferred to
profit or loss as they occur.
o Only if the entity meets the strict requirements set out in
paragraph 88 of AASB 139, the gains and losses on the hedging
instrument (in this case, on the futures) may initially be taken
directly to equity (and treated as part of other comprehensive
income in the statement of comprehensive income) and
subsequently transferred to profit or loss pursuant to paragraph
95 of AASB 139 so as to offset the losses on the item that was
the subject of the hedge (in this case, the receivable
denominated in an overseas currency).
Exception:
 o If assumed not a designated hedge, the gain or loss associated
with the hedging arrangement would be taken directly to the
periods profit or loss.
A hedge can exist that is not a designated hedgeit is up to the
entity to explicitly document that it wants to adopt hedge
accounting as stipulated within AASB 139. If this course of action
is not taken the hedging instrument is to be adjusted directly
through profit or loss.

35.

a) What is hedge accounting and what are the 3 types of hedges

identified in AASB 139?
Hedging transaction: When an entity enters an agreement that takes a
position opposite to the original transaction.
Hedge accounting is undertaken to account for the hedging
transaction.
Purpose of hedge accounting:
Recognise the offsetting effects on profit or loss of changes in the
fair values of the hedging instrument and the hedged item.

There are three main types of hedges, these being:

fair value hedges

cash-flow hedges
hedges of net investments in a foreign operation.

b) What is a hedged item and a hedging instrument?

Hedging instrument is a designated derivative or (for a hedge of
the risk of changes in foreign currency exchange rates only) a
designated non-derivative financial asset or non-derivative 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
Hedged item is an asset, liability, firm commitment, highly
probable forecast transaction or net investment in a foreign
operation that:
 a) exposes the entity to risk of changes in fair value or future
cash flows and
b) is designated as being hedged

c) How are gains/losses on the hedging instrument to be treated

for accounting purposes for a fair value hedge and a cash flow
hedge respectively?
For a fair value hedge, both the hedged item and the hedging
instrument to be valued at fair value with any gains or losses due
to the fair value adjustments to be treated as part of the periods
profit or loss.
If the gains or losses on the hedged item are perfectly hedged
then the gains or losses on the hedging instrument will offset the
gains or losses on the hedged item such that the net effect on
the periods profit or loss could be $nil.

For a cash-flow hedge, the gain or loss on measuring the

hedged item at fair value is to be treated as part of the periods
profit or loss.
The gain or loss on the hedging instrument is to be initially
transferred to equity, but subsequently transferred to profit or
loss as necessary to offset the gains or losses recorded on the
hedged item.
At the conclusion of the hedging arrangement, any amount still
in equity as relating to the hedging instrument shall be
transferred to profit or loss.

Hedges of a net investment in a foreign operation,

including a hedge of a monetary item that is accounted for as
part of the net investment (see AASB 121), paragraph 102 of
AASB 139 requires that the hedge shall be accounted for
similarly to cash-flow hedges. Specifically:
(i) the portion of the gain or loss on the hedging instrument
that is determined to be an effective hedge (see
paragraph 88) shall be recognised directly in equity
through the statement of changes in equity (see AASB
101); and
(ii) the ineffective portion shall be recognised in profit or loss.
The gain or loss on the hedging instrument relating to the
effective portion of the hedge that has been recognised
 directly in equity shall be recognised in profit or loss on
disposal of the foreign operation.

Try Q36 futures contract

Try Q38 convertible bond
*check ans w/ her