Chapter 9 Financial Instruments

LEARNING OBJECTIVES 1. 2. 3. 4. 5. 6. Apply and discuss the recognition and derecognition of a financial asset or financial liability. Apply and discuss the classification of a financial asset or financial liability and their measurement. Apply and discuss the treatment of gains and losses arising on financial assets and financial liabilities. Apply and discuss the treatment of impairment of financial assets. Record the accounting for derivative financial instruments, and simple embedded derivatives. utline the principle of hedge accounting, and account for fair value hedges and cash flo! hedges including hedge effectiveness.

214

# in a n c ia l $ n s t r u m e n ts /# $0

" la s s ific a tio n of #$

R e c o g n itio n of #$

% e a s u re m e n t o f # in a n c ia l A s s e ts

% e a s u re m e n t o f # in a n c ia l ) ia b ilitie s

* e re c o g n itio n

$m p a irm e n t

* e riv a tiv e s

. edge A c c o u n tin g

* is c lo s u re

$n itia l % e a s u re m e nt

- ubse,uent % e a s u re m e n t

-ubse,uent % e a s u re m e n t

% e a s u re m e n t

# a ir & a lu e . edge " a s h # lo ! . edge

* ebt $ n s t r u m e n ts

+ , u i ty $ n s t r u m e n ts

# a ir & a lu e ' h r o u g h ( r o f it o r ) o ss A t A m o rtis e d " o st

# a ir & a lu e ' h r o u g h ( r o f it o r ) o ss

# a ir & a lu e ' h r o u g h ( r o f it o r ) o ss

# a ir & a lu e p tio n A t A m o rtis e d " o st # a ir & a lu e ' h ro u g h th e r " o m p re h e n s iv e $n c o m e

215

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1.1

Intr!"ucti!n
'here are four reporting standards that deal !ith financial instruments1 /a0 $A- 32 #inancial instruments1 presentation *eals !ith the classi#icati!n !# #inancial instruments and their presentation in financial statements. /b0 $A- 32 #inancial instruments1 recognition and measurement *eals !ith ho! financial instruments are measured and !hen they should be recogni3ed in financial statements. /c0 $#R- 4 #inancial instruments1 disclosures *eals !ith the disclosure of financial instruments in financial statements. /d0 $#R- 2 #inancial instruments $ssued on 5ovember 2662 and revised on *ecember 2616. $t !ill eventually replace $A- 32 and effective for accounting periods commencing from 1 7anuary 2615. .istory of $#R- 21 Time $r!cess $A-8 issues e9posure draft #inancial $nstruments1 "lassification and %easurement $A-8 issues $#R- 2 #inancial $nstruments, covering classification and measurement of financial assets, as the first part of its pro:ect to replace $A- 32. $A-8 reissues $#R- 2 #inancial $nstruments, incorporating ne! re,uirements on accounting for financial liabilities and carrying over from $A- 32 the re,uirements for derecognition of financial assets and financial liabilities. $A-8 publishes an e9posure draft proposing to push bac< the mandatory effective date of $#R- 2 #inancial $nstruments from 1 7anuary 2613 to 1 7anuary 2615 $A-8 publishes %andatory +ffective *ate and 'ransition *isclosures /Amendments to $#R- 2 and $#R- 40, !hich amends the effective date of $#R- 2 to annual periods beginning on or after 1 7anuary 2615, and modifies the relief from restating comparative periods and the associated disclosures in $#R- 4 riginal effective date of $#R- 2, !ith early adoption permitted starting in 2662 Revised effective date of $#R- 2, !ith early adoption permitted

1.2

14 7uly 2662 12 5ovember 2662

2; ctober 2616

4 August 2611

16 *ecember 2611

1 7anuary 2613 1 7anuary 2615

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2.1

Classi#icati!n !# Financial Instruments &IAS '%(

)e#initi!ns /a0 /b0 A #inancial instrument is any c!ntract that gives rise to a financial asset of one entity and a financial liability or e,uity instrument of another entity. A #inancial assets is any asset that is1 /i0 cash /ii0 a contractual right to receive cash or another financial asset from another entity /iii0 a contractual right to e9change financial assets=liabilities !ith another entity under conditions that are potentially favourable to the entity /iv0 a contract that !ill or may be settled in the entity>s o!n e,uity instruments, and is a non?derivative for !hich the entity is or may be obliged to receive a variable number of the entity>s o!n e,uity instruments /v0 a contract that !ill or may be settled in the entity>s o!n e,uity instruments, and is a derivative that !ill or may be settled other than by the e9change of a fi9ed amount of cash or another financial asset for a fi9ed number of the entity>s o!n e,uity instruments. +9amples1 'rade receivables ptions $nvestment in e,uity shares A #inancial lia*ilit+ is any liability that is a c!ntractual !*li,ati!n1 /i0 to deliver cash or another financial asset to another entity, or /ii0 to e9change financial instruments !ith another entity under conditions that are potentially unfavourable, or /iii0 a contract that !ill or may be settled in the entity>s o!n e,uity instruments, and is a non?derivative for !hich the entity is or may be obliged to deliver a variable number of the entity>s o!n e,uity instruments /v0 a contract that !ill or may be settled in the entity>s o!n e,uity instruments, and is a derivative that !ill or may be settled other than by the e9change of a fi9ed amount of cash or another financial asset for a fi9ed number of the entity>s o!n e,uity instruments.
214

/c0

/d0

+9amples1 'rade payables *ebenture loans Redeemable preference shares An e-uit+ instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

2.2

E.ample 1 $dentify !hich of the follo!ing are financial instruments1 /a0 inventories /b0 investment in ordinary shares /c0 prepayments for goods or services /d0 liability for income ta9es /e0 a share option /an entity>s obligation to issue its o!n shares0 S!luti!n/ /a0 $nventory /or any other physical asset such as non?current assets0 is n!t a #inancial instrument since there is n! present c!ntractual ri,ht to receive cash or other financial instruments. An investment in ordinary shares is a #inancial asset since it is an e-uit+ instrument !# an!ther entit+. (repayments for goods or services are n!t #inancial instruments since the future economic benefits !ill be the receipt !# ,!!"s !r ser0ices rather than a #inancial asset. A liability for income ta9es is n!t a #inancial instrument since the obligation is statut!r+ rather than c!ntractual. A share option is a financial instrument since a c!ntractual !*li,ati!n "!es e.ist t! "eli0er an e-uit+ instrument. 5ote, ho!ever, that an option buy or sell an asset other than a financial instrument /e.g. a commodity0 !ould not ,ualify as a financial instrument.

/b0 /c0

/d0 /e0

2.3

'he accounting treatment of interest, dividends, losses and gains relating to a financial instrument follo!s the treatment of the instrument itself. #or e9ample, dividends paid in respect of preference shares classified as a liability !ill be charged as a finance e9pense through profit or loss. *ividends paid on shares classified as e,uity !ill be
21;

reported in the statement of changes in e,uity. (a) 2.4 Classification as liabilities and/or equity +ntities that issue financial instruments should classify them as either liabilities or e,uity. 'his classification should be made in accordance !ith the su*stance, n!t merel+ the le,al #!rm, of the instrument. 'he substance of a financial instrument may differ from its legal form. -ome financial instruments ta<e the legal form of e,uity but are liabilities in substance. thers may combine features associated !ith e,uity and features associated !ith liabilities. 'he critical #eature in "i##erentiatin, a #inancial lia*ilit+ #r!m an entit+ instrument is the e.istence !# a c!ntractual !*li,ati!n on one party to the financial instrument /the issuer0 either to deliver cash or another financial asset to the other party /the holder0 or to e9change another financial instrument !ith the holder under conditions that are potentially unfavorable to the issuer. @hen such a contractual obligation e9ists, that instrument meets the definition of a financial liability regardless of the manner in !hich the contractual obligation !ill be settled. A restriction on the ability of the issuer to satisfy an obligation, such as lac< of access to foreign currency or the need to obtain approval for payment from a regulatory authority, does not negate the issuer>s obligation or the holder>s right under the instrument. @hen a financial instrument does not give rise to a contractual obligation on the part of the issuer to deliver cash or another financial asset or to e9change another financial instrument under the conditions that are potentially unfavourable, it is an e,uity instrument. E.ample % 1 Lia*ilities !r e-uit+2 /a0 $re#erence shares $f an entity issues preference shares that pay a fi9ed rate of dividend and that have a mandatory redemption feature at a future date, the su*stance is that there is a c!ntractual !*li,ati!n and, therefore, the preference shares should be recogni3ed as a financial liability. $n contrast, normal /ordinary0 shares should be classified as e,uity as the entity does not have a contractual obligation to ma<e any payment. $utta*le instruments & ( issue" *+ mutual #un"s3 unit trusts !r c!4!perati0es (uttable instrument is a financial instrument that gives the holder the right to

2.5

2.6

2.4

2.;

2.2

/b0

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/c0

return it to the issuer for cash or another financial asset. Although the legal form of such financial instruments often includes a right to the residual interest in the assets of an entity, the inclusion of an option for the h!l"er t! put the instrument *ac5 t! the entit+ #!r cash !r an!ther #inancial asset means that the instruments meet the "e#initi!n !# a #inancial lia*ilit+, an !*li,ati!n. Share 6arrants !r ri,hts -hare !arrant or right should be classified as e,uity. 'here is a contract that is settled by the issuer delivering a fi9ed number of the issuer>s o!n shares in e9change for a fi9ed amount of cash or monetary assets.

'

Rec!,niti!n !# Financial Assets an" Financial Lia*ilities un"er IFRS 9 an" IAS '9
Initial rec!,niti!n !# #inancial assets an" #inancial lia*ilities /a0 An entity should rec!,ni7e a #inancial asset !r a #inancial lia*ilit+ on its statement of financial position !hen, and only !hen, it *ec!mes a part+ t! the c!ntractual pr!0isi!ns of the instrument, rather than !hen the contract is settled. /Applied to $#R- 2 and $A- 320 At initial recognition, an entity has an !pti!n t! irre0!ca*l+ "esi,nate a #inancial asset !r a #inancial lia*ilit+ as measure" at #air 0alue thr!u,h pr!#it !r l!ss. 'his option is termed as A#air 0alue !pti!nB and is an accounting policy choice. / nly applied to $#R- 20

3.1

/b0

3.2

+9amples of this principle are as follo!s1 /a0 Cnconditional receivables are recogni3ed !hen the entity becomes a party to the contract. At that point the entity has a legal right to receive cash. /b0 "ommitments to sell goods, etc. are not recogni3ed until one party has fulfilled its part of the contract. #or e9ample, a sales order !ill not be recogni3ed as revenue and a receivable until the goods have been delivered. /c0 #or!ard contracts are recogni3ed as assets on the commitment date, not on the date !hen the item under contract is transferred from seller to buyer.

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81 4.1.1

9easurement !# Financial Assets un"er IAS '9

Initial measurement Initial measurement !# #inancial assets un"er IAS '9 /a0 A financial asset or liability should initiall+ *e measure" at is #air 0alue upon initial recognition. .o!ever, a financial asset n!t :at #air 0alue thr!u,h pr!#it !r l!ss; shall be measure" at #air 0alue plus transacti!n c!st that are directly attributable to the ac,uisition or issue of the financial asset or financial liability. 'ransaction costs are incremental costs that are directly attributable for the transaction !hich include commissions paid to agents, advisers, bro<ers, and dealersD levies by regulatory agencies and securities e9changesD and transfer ta9es and duties, etc.

/b0

8% 4.2.1

Su*se-uent measurement #or the purpose of measurement, $A- 32 classifies financial assets into #!ur cate,!ries1 /a0 #inancial assets at #air 0alue thr!u,h pr!#it !r l!ss, !hich comprise /i0 Eheld for trading> securities /ii0 Edesignated> securities /b0 <el"4t!4maturit+ &<T9( investments are financial assets !ith fi9ed or determinable payments and fi9ed maturity that an enterprise has the positive intent and ability to hold to maturity, other than loans and receivables originated by the enterprise. /c0 L!ans an" recei0a*les are non?derivative financial assets !ith fi9ed or determinable payments that are not ,uoted in an active mar<et, and that are created by the entity by providing goods, service or money directly to a receivable. /d0 A0aila*le4#!r4sale &AFS( financial assets are any remaining financial assets that do not fall into any of the three categories above. An e9ample !ould be an investment in shares !hich have a ,uoted price that is not held for trading. +,ually, an investment in an e,uity instrument that is not ,uoted and !hich there is no intention to sell is also classified as available for sale.

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4.2.2 'he four types of financial instruments are measured as follo!s. Financial instrument 9easurement at rec!,niti!n Su*se-uent measurement %easured at fair value !ith changes in value ta<en through the income statement %easured at amortised cost using the effective interest rate %easured at amortised cost using the effective interest rate Recognised at fair value !ith changes in value ta<en to e,uity and recycled once the asset is disposed of Rec!,niti!n in inc!me statement = e-uit+ $nterest=dividends ta<en through profit or loss. #air value gains and losses recogni3ed in income statement 'he interest calculated using the effective rate is credited to the income statement as finance income 'he interest calculated using the effective rate is credited to the income statement as finance income Fains and losses are initially recogni3ed in e,uity. @hen an asset is sold /or impaired or derecognised0 the cumulative gain or loss previously recogni3ed in e,uity is recycled to the income statement

#inancial assets #air value and liabilities at fair value through profit or loss )oans and receivables Amortised cost

.eld?to?maturity Amortised cost investments

Available?for?sale #air value financial assets

4.2.3

E.ample ' 1 AFS in0estment measure" at #air 0alue A8" )td ac,uires the follo!ing shares in the .ong Gong -toc< +9change /.G-+0 on 15 5ovember 2611. Assume that the shares !ere ac,uired as long?term investments, and therefore are classified as A#- investments. /a0 166,666 ordinary shares of )%5 )td at H2.66 per share plus transaction costs of H3,666D and /b0 266,666 ordinary shares of IJK )td at H3.66 per share plus transaction costs of H5,666.

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At is accounting year?end on 31 *ecember 2611, the shares are ,uoted at the .ong Gong -toc< +9change at the follo!ing prices1 /a0 rdinary shares of )%5 )td1 H1.56 per shareD and /b0 rdinary shares of IJK )td1 H4.66 per share. Assume further that at is accounting?year end on 31 *ecember 2612, the shares are ,uoted on the .G-+ at the follo!ing prices1 /a0 rdinary shares of )%5 )td1 H1.36 per shareD and /b0 rdinary shares of IJK )td1 H3.16 per share. $n this case, the relevant :ournal entries !ill be as follo!s1 1> N!0em*er %?11 $nvestment in A#- securities "ash '1 )ecem*er %?11 $nvestment in A#- securities #air value reserve 31 *ecember 2612 #air value reserve $nvestment in A#- securities )r &@( ;6;,666 Cr &@( ;6;,666

142,666 142,666

266,666 266,666

$n its 2611 financial statements1 /a0 $nvestment in A#- securities !ill be presented at its fair value of H256,666 in the statement of financial position. /b0 'he fair value gain on investment in A#- securities of H142,666 !ill be recogni3ed in other comprehensive income and accumulated in fair value reserve on A#- securities. 'he fair value reserve on A#- securities of H142,666 !ill be presented as part of shareholders> e,uity in the statement of financial position. $n its 2612 financial statements1 /a0 $nvestment in A#- securities !ill be presented at its fair value of H456,666 in the statement of financial position. /b0 'he fair value loss on investment in A#- securities of H266,666 !ill be recogni3ed in other comprehensive income and reduced the fair value reserve on A#- securities, resulting in a debt balance of H5;,666 to be presented as
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part of shareholders> e,uity in the statement of financial position.

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>1 5.1.1

9easurement !# Financial Assets un"er IFRS 9

Initial measurement Initial measurement !# #inancial assets All financial instruments are initiall+ measure" at #air 0alue plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs.

>% 5.2.1

Su*se-uent measurement T6! classi#icati!ns !# #inancial assets $#R- 2 divides all financial assets into t!o classifications1 /a0 those measure" at am!rtise" c!stD and /b0 those measure" at #air 0alue. Classi#icati!n is ma"e at the time the #inancial asset is initiall+ rec!,ni7e" , namely !hen the entity becomes a party to the contractual provisions of the instrument.

(a) 5.2.2

Debt instruments )e*t instruments *ebt instruments !ould n!rmall+ *e measure" at #air 0alue thr!u,h pr!#it !r l!ss /#&'()0, *ut c!ul" *e measure" at am!rtise" c!st /net of any !ritedo!n for impairment0 if the entity chooses to do so, provided the follo!ing t!o tests are passed1 /a0 Business m!"el test L /i0 +stablishes !hether the entity holds the financial asset to c!llect the c!ntractual cash #l!6s !r !hether the ob:ective is t! sell the #inancial asset pri!r t! maturit+ t! reali7e chan,es in #air 0alue. /ii0 $f it is to c!llect the c!ntractual cash #l!6s, it implies that there !ill be n! !r #e6 sales !# such #inancial assets from a portfolio to their maturity date.

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/b0

$f this is the case, the test is passe". $f n!t, it !ould suggest that it may be "isp!se" !# t! resp!n" t! chan,es in #air 0alue. $n this situation, the test is failed and the financial asset cann!t be measure" at am!rtise" c!st. /v0 @here an entity chan,es its *usiness m!"el, it may be re-uire" t! reclassi#+ its financial assets as a conse,uence, but this is e9pected to be infre,uent occurrence. /vi0 $f reclassification does occur, it is accounted for from the first day of the accounting period in !hich reclassification ta<es place. C!ntractual cash #l!6 characteristics test L /i0 *etermines !hether the c!ntractual terms of the financial asset ,i0e rise t! cash #l!6s !n speci#ie" "ates that are s!lel+ pa+ments !# principal an" interest *ase" up!n the principal am!unt !utstan"in,. /ii0 $f this is n!t the case, the test is failed and the #inancial asset cann!t *e measure" at am!rtise" c!st. /iii0 #or e9ample, convertible bonds contain rights in addition to the repayment of interest and principal and therefore !ould fail the test and must be accounted for as fair value through profit or loss.

5.2.3

5.2.4

+ven if a financial instrument passes both tests, it is still possible to designate a debt instrument as #&'() if doing so eliminates or significantly reduces a measurement or recognition inconsistency /i.e. acc!untin, mismatch0 that !ould other!ise arise from measuring assets or liabilities or from recogni3ing the gains or losses on them on different bases. 'herefore, it is no! possible to have financial assets that meet the criteria above and !hich !ill not be measured at amortised cost, even if they are ,uoted in an active mar<et. E.ample 8 1 )e*t in0estment measure" at am!rtise" c!st usin, the e##ecti0e interest meth!" n 1 7anuary 2611, IJK )td pays H164,336 to ac,uire a bond !hich has a nominal value of H166,666, a coupon rate of 6M interest payable on 31 *ecember each year and matures on 31 *ecember 2615. IJK )td holds the investment !ithin a business model !hose ob:ective is to hold the bond until maturity date in order to collect contractual cash flo!s. 'he company measures the investment in bond at amortised cost using the effective interest method. 'he effective interest rate is 5M.
225

5.2.5

$n this case, the carrying amount of the investment and the interest income for each relevant year !ill be determined, using the effective interest method, as follo!s1 Aear Openin, *alance H 164,336 163,546 162,423 161,;52 166,252 E##ect interest rate >B H 5,216 5,144 5,136 5,623 5,64; 25,646 'o1 $ncome statement 'he relevant :ournal entries are as follo!s1 1 Januar+ %?11 $nvestment in bond "ash '1 )ecem*er %?11 "ash $nvestment in bond /6,666 L 5,2160 $nterest income '1 )ecem*er %?1% "ash $nvestment in bond /6,666 L 5,1440 $nterest income '1 )ecem*er %?1' "ash $nvestment in bond /6,666 L 5,1360 $nterest income '1 )ecem*er %?18 "ash $nvestment in bond /6,666 L 5,6230 $nterest income '1 )ecem*er %?1> Interest recei0e" CB H /6,6660 /6,6660 /6,6660 /6,6660 /6,6660 /36,6660 'o1 -tatement of cash flo!s 'o1 -tatement of financial position Cl!sin, *alance H 163,546 162,423 161,;52 166,252 166,666

2611 2612 2613 2614 2615

)r &@( 164,336

Cr &@( 164,336

6,666 4;4 5,216 6,666 ;23 5,144 6,666 ;64 5,136 6,666 264 5,623

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"ash $nvestment in bond /6,666 L 5,64;0 $nterest income "ash $nvestment in bond

6,666 252 5,64; 166,666 166,666

(b) 5.2.6

Equity instruments E-uit+ instruments +,uity instruments are measured at either1 /a0 #air 0alue thr!u,h pr!#it !r l!ss, or /b0 #air 0alue thr!u,h !ther c!mprehensi0e inc!me.

5.2.4

5.2.;

'he n!rmal e.pectati!n is that e,uity instruments !ill have the designation of #air 0alue thr!u,h pr!#it !r l!ss, !ith the price paid to ac,uire the financial asset initially regarded as fair value. 'his could include un,uoted e,uity instruments, !hich may present problems in arriving at a reliable fair value at each reporting date. .o!ever, $#R- 2 does n!t inclu"e a ,eneral e.cepti!n #!r un-u!te" e-uit+ in0estments to be measured at costD rather it provides guidance on !hen cost may, or may not, be regarded as a reliable indicator of fair value. E.ample > 1 E-uit+ in0estment measure" at #air 0alue A8" )td ac,uires the follo!ing shares in the .ong Gong -toc< +9change on 15 5ovember 2611, !hich it intends to sell in early 2612 to ta<e advantage of the e9pected changes in the share prices. /a0 166,666 ordinary shares of )%5 )td at H2.66 per share plus transaction costs of H3,666D and /b0 266,666 ordinary shares of IJK )td at H3.66 per share plus transaction costs of H5,666. At is accounting year?end on 31 *ecember 2611, the shares are ,uoted at the .ong Gong -toc< +9change at the follo!ing prices1 /a0 rdinary shares of )%5 )td1 H1.56 per shareD and /b0 rdinary shares of IJK )td1 H4.66 per share.

5.2.2

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$n this case, the shares are financial assets at fair value through profit or loss as it is held for trading, and the relevant :ournal entries !ill be as follo!s1 1> N!0em*er %?11 )r &@( Cr &@( $nvestment in trading securities ;66,666 +9pense ;,666 "ash ;6;,666 '1 )ecem*er %?11 $nvestment in trading securities #air value gain

156,666 156,666

$n the statement of financial position as at 31 *ecember 2611, the investment in trading securities !ill be presented at its fair value of H256,666. $n the statement of comprehensive income for the year ended 31 *ecember 2611, the fair value gain on trading securities of H156,666 and the e9pense of H;,666 !ill be recogni3ed in profit or loss for the year. 5.2.16 Fair 0alue thr!u,h !ther c!mprehensi0e inc!me /a0 $t is possible to designate an entity instrument as #air 0alue thr!u,h !ther c!mprehensi0e inc!me, provided speci#ie" c!n"iti!ns ha0e *een c!mplie" 6ith as follo!s1 /i0 the e,uity instrument cann!t *e hel" #!r tra"in,, and /ii0 there must be an irre0!ca*le ch!ice for this designation upon initial recognition. $n this situation, initial rec!,niti!n !ill also inclu"e "irectl+ attri*uta*le transacti!ns c!sts. 'his may apply, for e9ample, to strategic investments to be held on a continuing basis !hich are not held to ta<e advantage of changes in fair value. +,uity derivatives are e9cluded from adopting this designation.

/b0

5.2.11 )i0i"en"s on financial assets through other comprehensive income must *e ta5en t! pr!#it !r l!ss, unless they represent a recovery of part of the investment. Chan,es in #air 0alue 6ill *e rec!,ni7e" in !ther c!mprehensi0e inc!me. 5.2.12 $f an e-uit+ instrument has been designated as #air 0alue thr!u,h !ther c!mprehensi0e inc!me, the re,uirements in $A- 32 to underta<e an assessment !# impairment n! l!n,er appl+ as all #air 0alue m!0ements n!6 remain in e-uit+.

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6.1

9easurement !# Financial Lia*ilities

$#R- 2 !as updated in ctober 2616 to include accounting for financial liabilities. $n principle, the recognition and measurement criteria contained in $A- 32 have been retained !ithin $#R- 2. T6! classes !# #inancial lia*ilities /a0 /b0 #inancial liabilities at #air 0alue thr!u,h pr!#it !r l!ss, and Other #inancial lia*ilities. 'his is the default class for financial liabilities if they are not at fair value through profit or lossD these financial liabilities are measured at am!rtise" c!st. 8orro!ing !ould normally be classed under this heading.

6.2

6.3

-ummary of t!o classes of financial liabilities Financial instrument 9easurement at rec!,niti!n Su*se-uent measurement Rec!,niti!n in statement !# c!mprehensi0e inc!me

#inancial liabilities at #air value fair value through profit or loss ther financial liabilities Amortised cost

%easured at fair #air value gains and value !ith changes in losses recogni3ed in value ta<en through profit or loss profit or loss %easured at amortised cost using effective interest rate 'he interest calculated using the effective rate is charged to profit or loss !ithin the income statement as a finance cost

(a) 6.4

Deep discounted bonds measured at amortised cost 'he deep discounted bond has the follo!ing features. /a0 'his instrument is issued at a significant discount to its par value. /b0 'ypically it has a coupon rate much lo!er than mar<et rates of interest, e.g. a 2M bond !hen mar<et interest is 16M pa. /c0 'he initial carrying amount of the bond !ill be the net proceeds of issue.

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/d0 /e0

'he full finance cost !ill be charged over the life of the instrument so as to give a constant periodic rate of interest. 'he full cost include1 /i0 issue costs /ii0 deep discount on issue /iii0 annual interest payments /iv0 premium on redemption

6.5

E.ample C 1 )eep "isc!unt *!n" n 1 7anuary 2612 A8" "o issued a deep discount bond !ith a H56,666 nominal value. 'he discount !as 16M of nominal value, and the costs of issue !ere H2,666. $nterest of 5M of nominal value is payable annually in arrears. 'he bond must be redeemed on 1 7anuary 2614 /after 5 years0 at a premium of H4,611. 'he effective rate of interest is 12M pa. Re-uire"/ .o! !ill this be reported in the financial statements of A8" "o over the period to redemptionN S!luti!n/ #irstly, !e must establish at !hat amount the bond !ill be initially recogni3ed in the statement of financial position. 'he calculation set out belo!, also !or<s out the total finance cost to be charged to profits. H Net pr!cee"s #ace value )ess1 16M discount )ess1 $ssue costs Initial rec!,niti!n !# lia*ilit+ Repa+ments "apital (remium on redemption (rincipal to redemption $nterest paid1 H56,666 O 5M O 5 years 56,666 /;,6660 /2,6660 46,666 H

56,666 4,611 54,611 12,566

236

64,111 T!tal #inance c!st 24,111

-econdly, !e set up a table /similar to that used for compound instruments0 to !or< out the balance of the loan at the end of each period. Aear Openin, *alance H 46,666 42,366 44,;46 44,461 56,222 E##ect interest rate 1%B H 4,;66 5,646 5,3;5 5,431 6,112 24,111 'o1 $ncome statement $a+ments >B H /2,5660 /2,5660 /2,5660 /2,5660 /2,5660 /12,5660 'o1 -tatement of cash flo!s 'o1 -tatement of financial position Cl!sin, *alance H 42,366 44,;46 44,461 56,222 54,611

1 2 3 4 5

'he finance charge ta<en to the income statement is greater than the actual interest paid, and so the balance sho!n as a liability increases over the life of the instrument until it e,uals the redemption value at the end of its term. $n years 1 to 4 the balance sho!n as a liability is less than the amount that !ill be payable on redemption. 'herefore the full amount payable must be disclosed in the notes to account. (b) 6.6 6.4 Compound instruments A compound instrument is financial instrument that has characteristics of both e,uity and liabilities, for e9ample debt that can be converted into shares. $A- 32 re,uires compound financial instruments be split int! their c!mp!nent parts1 /a0 a financial liability /the debt0 /b0 an e,uity instrument /the option to convert into shares0. 'hese must be sho!n separately in the financial statements. E.ample D 1 C!mp!un" instruments n 1 7anuary 2612, 88" "o issued a H56m three?year convertible bond at par.

6.;

231

'here !ere no issue costs. 'he coupon rate is 16M, payable annually in arrears on 31 *ecember. 'he bond is redeemable at par on 1 7anuary 2615. 8ondholders may opt for conversion. 'he terms of conversion are t!o 25?cent e,uity shares for every H1 o!ed to each bondholder on 1 7anuary 2615. 8onds issued by similar entities !ithout any conversion rights currently bear interest at 15M. Assume that all bondholders opt for conversion in full.

Re-uire"/ .o! !ill this be accounted for by 88" "oN S!luti!n/ n initial recognition, the method if splitting the bond bet!een e,uity and liabilities is as follo!s. "alculate the present value of the debt component by discounting the cash flo!s at the mar<et rate of interest for an instrument similar in all respects, e9cept that it does not have conversion rights. *educt the present value of the debt from the proceeds of the issue. 'he difference is the e,uity component. 1 Splittin, the pr!cee"s 'he cash payments on the bond should be discounted to their present value using the interest rate for a bond !ithout the conversion rights, i.e. 15M. )ate 31 *ec 12 31 *ec 13 31 *ec 14 1 7an 15 $nterest $nterest $nterest (rincipal Cash #l!6 @??? 5,666 5,666 5,666 56,666 )F E 1>B 6.;64 6.456 6.65; 6.65; $V @??? 4,344.; 3,4;6.4 3,2;4.6 32,;45.; 44,221.2 56,666.6 5,46;.1

(& /the liability component0 A As the net proceeds of issue !ere 8 -o the e,uity component is /8 L A0

232

The annual #inance c!sts an" +ear en" carr+in, am!unts Aear Openin, E##ect interest $a+ments Cl!sin, *alance *alance rate 1>B 1?B H H H H 2612 44,221.2 6,643.; /5,6660 45,235.4 2613 45,235.4 6,;26.4 /5,6660 44,;26.1 2614 44,;26.1 4,143.2 /5,6660 56,666.6

' The c!n0ersi!n !# the *!n" 'he carrying amounts at 1 7anuary 26121 +,uity )iability L bond H666 5,46;.1 56,666.6 55,46;.1 'he conversion terms are t!o 25?cent e,uity shares for every H1, so H56m O 2 P H166m shares, !hich have a nominal value of H25m. 'he remaining H36,46;,166 should be classified as the share premium, conversion has e9tinguished it. Fuesti!n 1 +psilon is a listed entity. Jou are the financial controller of the entity and its consolidated financial statements for the year ended 36 -eptember 2616 are being prepared. Jour assistant, !ho has prepared the first draft of the statements, is unsure about the correct treatment of a number of transactions and has as<ed for your advice. *etails of the transaction is given belo!1 n 1 ctober 2662 +psilon issued 5 million loan notes that had a value of H1 per note. 'he issue costs !ere 3 cents per note. +ach note holder !ill receive interest of 5 cents per note on 36 -eptember of each year starting on 36 -eptember 2616. 'he loan notes are repayable on 36 -eptember 2612 at H1Q26 per note. As an alternative to repayment the loan note holders can elect to e9change their notes for shares in +psilon. n 1 ctober 2662 the credit rating of +psilon !as such that it !ould have had to offer investors in non?convertible loan notes a rate of return of 2M per annum on any investment. 'he impact of issue costs !ould

233

increase the effective interest rate on such loan notes to 2Q45M. 'he follo!ing information regarding discount rates may be relevant1

)isc!unt rate 5M 2M

$resent 0alue !# @1 recei0a*le at the en" !# +ear 1? 61 cents 42 cents

Cumulati0e present 0alue !# @1 recei0a*le at the en" !# +ears 1 1 1? H4.42 H6.42

Re-uire"/ #or the above transaction prepare e9tracts from the financial statements for the year ended 36 -eptember 2616. Jour e9tracts should be supported by appropriate e9planations. /6 mar<s0 /Adapted A""A *iploma in $#R *ecember 2616 R3/a00 (c) 6.2 6.16 6.11 Fair value option for financial liabilities (IFRS 9 only) $#R- 2 permits entities to !pt t! "esi,nate lia*ilities !hich !ould normally fall to be measured at amortised cost, to be "esi,nate" at #air 0alue thr!u,h pr!#it !r l!ss. 'his designation, if made, must *e ma"e up!n initial rec!,niti!n an" is irre0!ca*le. @here an entity opts for this treatment, any change in fair value of the liability must be separated into t!o elements as follo!s1 /a0 "hanges in fair value due to !6n cre"it ris5, !hich are ta5en t! !ther c!mprehensi0e inc!me, and /b0 Other chan,es in #air 0alue, !hich are ta5en t! pr!#it !r l!ss. ne possible approach to identifying the t!o elements is to separate the interest rate charged on the financial liability into a *enchmar5 rate /e.g. )$8 R0 and an instrument4speci#ic rate. Any change in the fair value of the liability !hich is not !holly due to the change in benchmar< rate must therefore be "ue t! a chan,e !n !6n cre"it ris5. 'he movement in fair value can then be split into t!o separate elements. E.ample G 1 Fair 0alue !pti!n #!r lia*ilities n 1 7anuary 2612 an entity issues a 4?year bond at par value of H366,666 and annual fi9ed coupon rate of 2M, !hich is also the mar<et rate, !hen )$8 R is 6M.

6.12

6.13

234

'herefore the instrument?specific element of $RR is 3M /2M L 6M0. At 31 *ecember 2612, )$8 R has moved to 5.5M, thus ma<ing the benchmar< interest rate /5.5M S 3M0 ;.5M /i.e. )$8 R plus the instrument?specific element of $RR0. $f the fair value of the liability is consistent !ith a mar<et interest rate of, say, ;.3M, then any change in the fair value of the liability from the benchmar< rate to fair value must be due to something other than the change in the benchmar< rate L i.e. it must be due to the change in the liability>s credit ris<. Re-uire"/ "alculate the amounts to be included !ithin the financial statements for the year ended 31 *ecember 2612. S!luti!n/ $t can be ,uantified by calculating the present value /(&0 of the liability using the benchmar< rate and comparing it !ith the (& of the liability using the mar<et rate as follo!s1 $V at *enchmar5 rate G >B Cash #l!6 )F E G >B $V Aear @ @ 1L6 24,666 4.5533 122,232 6 366,666 6.6122 1;3,;46 366,;62 $V at mar5et rate G 'B Aear 1L6 6 Cash #l!6 @ 24,666 366,666 )F E G 'B 4.5;6; 6.6124 $V @ 123,6;2 1;5,216 362,522 'herefore, the change in the fair value of the liability !hich is not due to the change in the benchmar< rate must be due to the change in the liability>s credit ris<. H 362,522 366,;62

(& of liability at mar<et rate of ;.3M /on - #( at reporting date0 (& of liability at benchmar< rate of ;.5M

235

ther comprehensive income

2,4;3

$#R- 2 re,uires that this change in fair value relating to the change in the liability>s credit ris< is ta<en to other comprehensive income. $n the above situation, it !ill be reflected by a reduction in e,uity as the carrying value of the liability is increased.

236

D
4.1

)erec!,niti!n !# Financial Instruments

'he derecognition re,uirements of $A- 32 have been transferred to $#R- 2. *erecognition is currently part of the $A-8 !or< plan for the development of reporting standards, !hich includes a continuing commitment to convergence of $#R!ith C- FAA(. 'hese re,uirements may be changed at some future date, as practical issues associated !ith derecognition of financial instruments become apparent. )erec!,niti!n /a0 A #inancial asset should be derecogni3ed if one of the follo!ing criteria occur1 /i0 the c!ntractual ri,hts t! the cash #l!6s of the financial asset ha0e e.pire", e.g. !hen an option held by the entity has e9pired !orthless, or /ii0 the financial asset has been sold and the transfer ,ualifies for derecognition because su*stantiall+ all the ris5s an" re6ar"s !# !6nership ha0e *een trans#erre" from the seller to the buyer. 'he anal+sis !# 6here the ris5s an" re6ar"s !# !6nership lie after the transaction is critical. #or e9ample if an entity sells an investment in shares and enters into a total return s!ap !ith the buyer, the buyer !ill return any increases in value to the entity or the entity !ill pay the buyer for any decrease in value. $n this case the entity has retained substantially all of the ris<s and re!ards of the investment, !hich therefore should not be derecogni3ed. A #inancial lia*ilit+ should be derecogni3ed !hen, and only !hen, the !*li,ati!n speci#ie" in the c!ntract is "ischar,e"3 cancelle" !r e.pire". n "erec!,niti!n, the "i##erence *et6een the carr+in, am!unt of the asset or liability an" the am!unt recei0e" !r pai" for it should be rec!,ni7e" in the pr!#it !r l!ss #!r the peri!".

4.2

/b0

/c0

234

4.3

E.ample 9 1 )erec!,niti!n 'ech "o has t!o receivables that it has factored to a ban< in return for immediate cash proceeds of less than the face value of the invoices. 8oth receivables are due from long standing customers !ho are e9pected to pay in full and on time. 'ech "o has agreed a three?month credit period !ith both customers. 'he first receivable is for H266,666 and in return for assigning the receivable 'ech "o has :ust received from the factor H1;6,666. Cnder the terms of the factoring arrangement, the only money that 'ech "o !ill receive regardless of !hen or even if the customer settles the debt, i.e. the factoring arrangement is said to be A!ithout recourseB. 'he second receivable is for H166,666 and in return for assigning the receivable 'ech "o has :ust received H46,666. Cnder the terms of this, factoring arrangement if the customer settles the account on time then a further H5,666 !ill be paid by the factoring ban< to 'ech "o, but if the customer does not settle the account in accordance !ith the agreed terms then the receivable !ill be reassigned bac< to 'ech "o !ho !ill then be obliged to refund the factor the original H46,666 plus a further H16,666. 'his factoring arrangement is said to be A!ith recourseB. Re-uire"/ *iscuss 'ech "o>s accounting treatment of the monies received under the terms of the t!o factoring arrangements. S!luti!n/ 'he principle of derecognition here is that it needs to "etermine 6hether the ris5 an" re6ar"s !# !6nership !# the #act!rin, arran,ement has passe" from 'ech "o to the factoring ban<. 'he principal ris< !ith regard to receivables is the ris< of bad debt. $n the first arrangement the H1;6,666 has been received as a one?off non refundable sum. 'his is factoring 6ith!ut rec!urse #!r *a" "e*ts. 'he ris5 !# *a" "e*t has clearl+ passe" from 'ech "o to the factoring ban<. Accordingly 'ech "o should "erec!,ni7e the recei0a*le and there !ill be an e9pense of H26,666 recognised. 5o liability !ill be recogni3ed.

23;

$n the second arrangement the H46,666 is simply a payment on account. %ore may be received by 'ech "o implying that Tech C! retains an element !# re6ar". 'he monies received are refundable in the event of default and as such represent an obligation. 'his means that the ris5 !# sl!6 pa+ment an" *a" "e*t remains 6ith Tech C! !ho is liable to repay the monies so far received. As such despite the passage of legal title, the asset /i.e. receivable0 should remain rec!,ni7e" in the acc!unts !# Tech C!. $n substance 'ech "o has *!rr!6e" @D?3??? an" this l!an sh!ul" *e rec!,ni7e" imme"iatel+. 'his !ill increase the gearing of 'ech "o.

G
;.1

Impairment !# Financial Assets

Impairment !# #inancial assets $mpairment of financial assets !ill, in due course, be included !ithin updated re,uirements of $#R- 2. 'he present situation as at August 2616 is as follo!s1 /a0 Financial assets that are measured at #air 0alue thr!u,h pr!#it !r l!ss are n!t su*Hect t! an impairment re0ie6. Remeasurement !# #air 0alue at each reporting date !ill aut!maticall+ ta5e acc!unt !# an+ impairment. /b0 -imilarly, #inancial assets measured at #air 0alue thr!u,h !ther c!mprehensi0e inc!me are n!t su*Hect t! an impairment re0ie6. Any changes in fair value, including those !hich may relate to impairment, are recogni3ed in other comprehensive income. 'here is no recognition or recycling of impairment to profit or loss. /c0 #or #inancial assets measure" at am!rtise" c!st, $A- 32 re-uires that an assessment be made, at e0er+ rep!rtin, "ate, as to 6hether there is an+ !*Hecti0e e0i"ence that a #inancial asset is impaire" , i.e. !hether an event has occurred that has had a negative impact on the e9pected future cash flo!s of the asset. /d0 'he e0ent causin, the ne,ati0e impact must ha0e alrea"+ happene" . An event causing an impairment in the future shall not be anticipated. #or e9ample, on the last day of its financial year a ban< lends a customer H166,666. 'he ban< has consistently e9perienced a default rate of 5M across all its loans. 'he *an5 is n!t permitte" imme"iatel+ t! 6rite this l!an "!6n to H25,666 based on its past e9perience, because no default has occurred at the reporting date.

232

;.2

+9amples of ob:ective evidence of impairment at the reporting date include significant financial difficulty of the borro!er, and the failure of the borro!er to ma<e interest payments on the due date. E.ample 1? 1 Impairment !# #inancial assets measure" at am!rtise" c!st n 1 #ebruary 2662, A8" ban< ma<es a four?year loan of H16,666 to (aul. 'he coupon rate on the loan is 6M, the same as the effective rate of interest. $nterest is received at the end of each year. *uring #ebruary 2612, it becomes clear that (aul is in financial difficulties. 'his is the necessary ob:ective evidence of impairment. At this time the current mar<et interest rate is ;M. $t is estimated that the future remaining cash flo!s from the loan !ill be only H6,666, instead of H16,666 /the H16,666 principal plus interest for the fourth year of H6660. 8ecause the coupon rate and the effective rate are the same, the carrying amount of the principal !ill remain constant at H16,666. n 1 #ebruary 2612, the carrying amount of the loan should be restated to the present value of the estimated cash flo!s of H6,666, discounted at the original effective interest rate of 6M for one year.
6,666 = H5,666 1.66

;.3

'he result is an impairment loss of H4,346 /H16,666 L H5,6660. 'he impairment loss is recogni3ed as an e9pense in profit or loss. 'he asset !ill continue to be accounted for using amortised cost, based on the revised carrying amount of the loan. $n the last year of the loan, the interest income of H346 /5,666 O 6M0 !ill be recogni3ed in profit or loss. 9an+ -uesti!n this present value calculation because it uses the in0estmentIs hist!rical e##ecti0e4interest rate L n!t the current mar5et rate. As a result, the present value computation does n!t re#lect the #air 0alue of the debt investment, and many believe the impairment l!ss is misstate".

246

;.4

;.5

Re0ersal !# an impairment l!ss is !nl+ permitte" as a result of an e0ent !ccurrin, a#ter the impairment l!ss has *een rec!,ni7e" . An e9ample !ould be the credit rating of a customer being revised up!ards by a credit rating agency. Re0ersal !# impairment l!sses in respect of #inancial assets measure" at am!rtise" c!st are rec!,ni7e" in pr!#it !r l!ss.

9
2.1

)eri0ati0es
A derivative is a financial instrument !ith the follo!ing characteristics1 /a0 $ts 0alue chan,es in resp!nse t! the chan,e in a speci#ie" interest rate, security price, commodity price, foreign e9change rate, inde9 of prices or rates, a credit rating or credit inde9 or similar 0aria*le /called the un"erl+in,0. /b0 $t re,uires little !r n! initial net in0estment relative to other types of contract that have a similar response to changes in mar<et conditions. /c0 $t is settle" at a #uture "ate. 'he pr!*lems of derivates /a0 *erivatives !ere originally designed to hedge against fluctuations in agricultural commodity prices on the "hicago -toc< +9change. A speculator !ould pay a small amount /say H1660 no! for the contractual obligation to buy a thousand units of !heat in three months> time for H16,666. $f in three months time one thousand units of !heat costs H11,666, then the speculator !ould ma<e a profit of H266 /11,666 L 166 L 16,6660. 'his !ould be a 266M return on the original investment over 3 months. 8ut if the price had dropped to H2,666, then the trader !ould have made a loss of H1,166 /166 S 1,6660 despite the initial investment only having been H166. /b0 'his sho!s that l!sses !n "eri0ati0es can *e ,reater than the hist!rical c!st4 carr+in, am!unt !# the relate" asset . 'herefore, shareh!l"ers nee" t! *e ,i0en a""iti!nal in#!rmati!n a*!ut "eri0ati0es in order to assess the entity>s e9posure to loss. /c0 $n most cases, entering into a derivative is at a lo! cost. 'herefore it is imp!rtant that "eri0ati0es are rec!,ni7e" an" "iscl!se" in the #inancial statements as they have very little initial outlay but can e.p!se the entit+ t! si,ni#icant ,ains an" l!sses. 9easurement !# "eri0ati0es

2.2

9'

241

2.3.1

9easurement !# "eri0ati0es /a0 /b0 n recognition, derivatives should initiall+ *e measure" at #air 0alue. Su*se-uent measurement "epen"s !n ho! the derivative is cate,!ri7e". $n many cases, this !ill involve the derivative being measure" at #air 0alue 6ith chan,es in the #air 0alue rec!,ni7e" in pr!#it !r l!ss. .o!ever, i# the "eri0ati0e is use" as a he",e, then the chan,es in #air 0alue sh!ul" *e rec!,ni7e" in e-uit+.

/c0

2.3.2

E.ample 11 1 9easurement !# "eri0ati0es +ntity A enters into a call option on 1 7une 2612, to purchase 16,666 shares in another entity on 1 5ovember 2612 at a price of H16 per share. 'he cost of each option is H1. +ntity A has a year end of 36 -eptember. 8y 36 -eptember the fair value of each option has increased to H1.36 and by 1 5ovember to H1.56, !ith the share price on the same date being H11. +ntity A e9ercises the option on 1 5ovember and the shares are classified as at fair value through profit or loss. n 1 7une 2612, the cost of the option is recogni3ed1 *r. /H0 "all option /16,666 O H10 16,666 "ash n 36 -eptember the increase in fair value is recorded1 *r. /H0 "all option T16,666 O /H1.3 L H10U 3,666 (rofit or loss

"r. /H0 16,666

"r. /H0 3,666

n 1 5ovember the option is e9ercise, the shares recogni3ed and the call option derecogni3ed. As the shares are financial assets at fair value through profit or loss, they are recogni3ed at H116,666 /16,666 O H110 *r. /H0 "r. /H0 $nvestment in shares at fair value 116,666 +9pense L loss on call option 3,666 T/16,666 S 3,666 S 166,6660 L 116,666U "ash 166,666

242

"all option

13,666

243

1?
1? 1

<e",e Acc!untin, un"er IAS '9

)e#initi!ns

16.1.1 )e#initi!ns /a0 <e",in, is a meth!" !# mana,in, ris5 by designating one or more hedging instruments so that their change in fair value is offset, in !hole or in part, to the change in fair value or cash flo!s of a hedged item. A he",e" item is an asset !r lia*ilit+ that e.p!ses the entit+ t! ris5s !# chan,es in #air 0alue !r #uture cash #l!6s /and is designated as being hedged0. A he",in, instrument is a "esi,nate" "eri0ati0e !hose fair value or cash flo!s are e9pected to offset changes in fair value or future cash flo!s of the hedged item.

/b0

/c0

16.1.2 As at August 2616, IFRS 9 "!es n!t c!ntain an+ speci#ic re-uirements relatin, t! he",e acc!untin,D this constitutes the third phase of the pro:ect to replace $A- 32 !ith $#R- 2. Accordingly, the re,uirements specified in $A- 32 continue to apply until !ithdra!n. 1? % T+pes !# he",e

16.2.1 T6! t+pes !# he",es $A- 32 identifies three types of hedge, t!o !hich are !ithin the (2 syllabus1 /a0 Fair 0alue he",e L 'his hedges a,ainst the ris5 !# chan,es in the #air 0alue !# a rec!,ni7e" asset !r lia*ilit+. #or e9ample, the fair value of fi9ed rate debt !ill change as a result of changes in interest rates. /b0 Cash #l!6 he",e L 'his hedges a,ainst the ris5 !# chan,es in e.pecte" cash #l!6s. #or e9ample, a CG entity may have an unrecogni3ed contractual commitment to purchase goods in a year>s time for a fi9ed amount of Cdollars.

244

(a)

ccountin! for a fair value "ed!e

16.2.2 Cnder $A- 32 hedge accounting rules can only be applied to a fair value hedge if the hedging relationship meets #!ur criteria. /a0 At the inception of the hedge there must be #!rmal "!cumentati!n identifying the hedged item and the hedging instrument. /b0 'he hedge is e9pected to be hi,hl+ e##ecti0e. /c0 'he e##ecti0eness !# the he",e can *e measure" relia*l+ /i.e. the fair value=cash flo!s of the item and the instrument can be measured reliably0. /d0 'he hedge has been assesse" !n an !n4,!in, *asis an" is "etermine" t! ha0e *een e##ecti0e. 16.2.3 $t should be noted at the outset that !hether or not to hedge, and !hether or not to apply hedge accounting are t!o separate issues. nce an entity decides to hedge, it still has to decide !hether or not to apply hedge accounting. <e",e acc!untin, is n!t c!mpuls!r+. .o!ever, to be able to apply hedge accounting, the conditions stated above must first be fulfilled. 16.2.4 <e",e acc!untin, *asicall+ all!6s the #air 0alue ,ain !r l!ss arisin, #r!m chan,e in #air 0alue !# the he",e" item an" the he",in, instrument t! *e !##set during the same accounting periods, and thereby reduces the volatility of the periodic profit or loss. 16.2.5 <e",e e##ecti0eness ne of the re,uirements of $A- 32 is that to use hedge accounting, the hedge must be effective. $A- 32 describes this as the "e,ree t! 6hich the chan,es in #air 0alue !r cash #l!6s !# the he",e" item are !##set *+ chan,es in the #air 0alue !r cash #l!6s !# the he",in, instrument. A hedge is vie!ed as being hi,hl+ e##ecti0e if actual results are 6ithin a ran,e !# G?B t! 1%>B.

245

16.2.6 E.ample 1% 1 <e",e e##ecti0eness n 1 7anuary 2612 an entity purchased an e,uity instrument at a fair value of H266,666. As it !as not ac,uired !ith the intention of ta<ing advantage of short?term changes in fair value, it !ould normally be designated upon initial recognition to be classified as fair value through other comprehensive income. *ue to the e9posure to ris< of changes in fair value of the e,uity instrument, the entity entered into an interest rate s!ap, identifying the s!ap contract as a hedging instrument as part of a fair value hedging arrangement. 'he fair value hedge has been correctly documented and designated upon initial recognition and is e9pected to be an effective hedging instrument. "onse,uently, changes in fair value to both the e,uity instrument /hedged item0 and the s!ap contract /hedge instrument0 !ill be matched in profit or loss, rather than accounted for separately. At the reporting date 31 *ecember 2612, the fair value of the e,uity instrument has fallen to H;66,666, and there has been an increase in the fair value of the interest rate s!ap contract of H26,666. Re-uire"/ $llustrate and e9plain the accounting treatment for the fair value hedge arrangement based upon the available information. S!luti!n/ 'he fall in fair value of the entity interest of H166,666 is ta<en to profit or loss. 'his is matched !ith the increase in fair value of the interest rate s!ap contract of H26,666, resulting in a small net loss H16,666. 'he effectiveness in the hedge arrangement can be evaluated by comparing the change in the hedged item and the hedged instrument as follo!s1 "hange in hedged item H166,666 "hange in hedging instrument H26,666 +ither1 166,666=26,666 P 111M r1 26,666=166,666 P 26M

246

As long as either one of the t6! measures a*!0e #alls 6ithin the ran,e G?B 1 1%>B3 the he",e is re,ar"e" as e##ecti0e. 16.2.4 Acc!untin, treatment #!r #air 0alue he",e /a0 /b0 'he he",in, instrument !ill be remeasure" at #air 0alue, !ith all ,ains an" l!sses being rep!rtin, in pr!#it !r l!ss #!r the +ear. 'he he",e" p!rti!n of the hedged item !ill be remeasure" at #air 0alue, !ith all ,ains an" l!sses *ein, rep!rte" in pr!#it !r l!ss #!r the +ear

16.2.; E.ample 1' 1 Fair 0alue he",e .G )td /a company incorporated in .G and !ith 31 *ecember accounting year? ends0 has, on 1 April 2611, sold goods to #" )td /a company incorporated in a foreign country0 invoiced at #" 166,666 payable 36 -eptember 2611. 'he e9change rates bet!een #" and H at the relevant dates are as follo!s1 n 1 April 26111 -pot rate1 -i9?month rate1 n 36 -eptember 26111 -pot rate1 #"1.66 P H6.55 #"1.66 P H6.65 #"1.66 P H6.63

Scenari! A .G )td decides not to hedge the foreign currency e9posure. 'he relevant :ournal entries !ill be as follo!s1 1 April %?11 'rade receivable /#"166,666 O H6.650 -ales '? Septem*er %?11 "ash +9change loss 'rade receivable *r. /H0 65,666 "r. /H0 65,666 55,666 16,666 65,666

*ue to unfavourable shift in the e9change rate, .G )td suffers an e9change loss of

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H16,666. Scenari! B .G )td decides to hedge the foreign currency e9posure by entering into a for!ard e9change contract on 1 April 2611 to sell #"166,666 on 36 -eptember 2611. .G )td further decides to apply hedge accounting. 'his is a fair value hedge under $A- 32. Csing the for!ard rate as the basis of measurement, the :ournal entries to record the transactions !ill be as follo!s1 1 April %?11 'rade receivable /#"166,666 O H6.630 -ales /'o record sales0 *r. /H0 63,666 "r. /H0 63,666

5o :ournal entry is re,uired for the for!ard e9change contract. 7ust a memorandum entry to record the fact that a for!ard e9change contract has been entered into as a fair value hedge. '? Septem*er %?11 "ash #air value loss 'rade receivable /'o record receipt of #"166,6660

55,666 ;,666 63,666

ther receivables ;,666 #air value gain /'o record fair value ad:ustment for contract receivable0 "ash ;,666 ther receivables /'o record net settlement of for!ard e9change contract0

;,666

;,666

5ote that, !ith the fair value hedge, .G )td is protected from the foreign currency ris<. Regardless of the e9change rate prevailing on 36 -eptember 2611, the sales !ill be recorded at H63,666 /sales price of #"166,666 at loc<?in e9change rate of #"1.66 P H6.630, and the net cash receipt is H63,666 /H55,666 S H;,6660. Also the fair value

24;

loss on the trade receivable !ill be e9actly offset by the fair value gain on the for!ard e9change contract. 5ote ho!ever that there is a cost involved, namely, the margin made by the foreign currency dealer of H6.62 /H6.65 L H6.630. 'his may be more evidently reflected in the alternative treatment sho!n belo!. 1 April %?11 'rade receivable /#"166,666 O H6.650 -ales /'o record sales0 "ontract receivable (remium "ontract payable /'o record for!ard e9change contract0 '? Septem*er %?11 "ash #air value loss 'rade receivable /'o record receipt of #"166,6660 *r. /H0 65,666 "r. /H0 65,666 63,666 2,666 65,666

55,666 16,666 65,666

"ontract payable 16,666 #air value gain /'o record fair value ad:ustment for contract payable0 "ash ;,666 "ontract payable 55,666 "ontract receivable /'o record net settlement of for!ard e9change contract0

16,666

63,666

5ote that, due to the fair value hedge, .G )td is able to loc<?in at the rate of #"1.66 P H6.63. $n the profit or loss, there is a sales of H65,666, a premium e9pense of H2,666, and no fair value gain or loss. 'he premium charge represents the cost of hedging. 'he net cash receipt is H63,666 /H55,666 S H;,6660. (b) ccountin! for a cas" flo# "ed!e

16.2.2 8efore the $A- 32 hedge accounting rules can be applied to a cash flo! hedge, the hedging relationship must meet #i0e criteria. 'hese are the #!ur liste" #!r a #air 0alue

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he",e3 plus1 /e0 the transaction ,i0in, rise t! the cash #l!6 ris5 is hi,hl+ pr!*a*le an" !ill ultimatel+ a##ect pr!#ita*ilit+. 16.2.16 Acc!untin, treatment #!r cash #l!6 he",e /a0 'he hedging instrument !ill be remeasure" at #air 0alue. 'he ,ain !r l!ss on the portion of the instrument that is "eeme" t! *e an e##ecti0e he",e !ill be ta5en t! e-uit+ and recogni3ed in the statement of changes in e,uity. 'he ine##ecti0e p!rti!n !# the ,ain !r l!ss !ill be rep!rte" imme"iatel+ in the inc!me statement. $f the he",e" item e0entuall+ results in the rec!,niti!n !# a n!n4#inancial asset !r lia*ilit+, the ,ain !r l!ss hel" in e-uit+ must be rec+cle" in !ne !# the t6! #!ll!6in, 6a+s. /i0 the ,ain=l!ss ,!es t! a"Hust the carr+in, am!unt !# the n!n4 #inancial assets=lia*ilit+. /ii0 the ,ain=l!ss is trans#erre" t! pr!#it an" l!ss in line 6ith the c!nsumpti!n !# the n!n4#inancial assets=lia*ilit+.

/b0 /c0

16.2.11 E.ample 18 1 Cash #l!6 he",e A8" "o has contracted to buy one hundred tonnes of ra! materials from a Ferman entity. 'he materials !ill cost V566,666, and !ill be delivered and paid for in +uros on 36 7une 2612. A8" "o ta<es out a for!ard contract to buy V566,666 on 36 7une 2612 at a cost of H326,666. At the year end of 36 April 2612, the +uro has appreciated and the value of V566,666 is no! H325,666. Re-uire"/ .o! should this be accounted forN S!luti!n/ $t is assumed that, at its inception, the for!ard contract has a cost, and fair value, of 3ero. 'he cost of the materials is still V566,666 at the reporting date but this is no! e,uivalent to H325,666, !hereas the for!ard contract ensures that it !ill only cost the

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entity H326,666. 'herefore the hedge has been completely effective. And therefore the entire change in the fair value of the hedging instrument, the for!ard contract, is recogni3ed as other comprehensive income and recorded in a cash flo! hedge reserve !ithin other components in e,uity. *r. /H0 "r. /H0 #or!ard contract 5,666 "ash flo! hedge reserve 5,666 $f the for!ard contract is then settled !ith no further changes in e9change rates, the for!ard contract !ill be settled for H326,666 cash and the materials valued at cost of H325,666. 'he materials are purchased for V566,666 !ith a value of H325,666 and are recorded as1 *r. /H0 "r. /H0 %aterial 325,666 "ash 326,666 #or!ard contract 5,666 8ecause the cash flo! hedge resulted in the recognition of materials /a non?financial asset0, the gain of H5,666 held in the cash flo! hedge reserve is dealt !ith as follo!s. $t is immediately deducted from the H325,666 cost of the materials, to bring the carrying amount bac< to H326,666. $t is recogni3ed in profit or loss as the materials are charged to cost of sales. +ither !ay, the net cost of the materials in profit or loss over time is H326,666. Fuesti!n % n 1 7anuary 2611, mega signed a contract to purchase a machine from a foreign supplier on 36 7une 2611. 'he purchase price of the machine, payable in cash on 36 7une 2611, !as 2 million shillings. n 1 7anuary 2611, mega entered into a for!ard contract to purchase 2 million shillings on 36 7une 2611 for H1Q1 million. n 31 %arch 2611, a contract to buy 2 million shillings on 36 7une 2611 !ould have re,uired a payment of H1Q2 million. n 36 7une 2611 the spot rate of e9change !as 1Q6 shillings P H1. 'he for!ard contract !as settled by the other party ma<ing a payment of H156,666 to mega on that date.

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mega estimated that the useful economic life of the machine !as five years from 36 7une 2611, !ith no residual value. mega uses hedge accounting !henever permitted by $A- 32 L #inancial $nstruments1 Recognition and %easurement. 'he currency contract fully complies !ith the criteria and conditions for hedge accounting as set out in $A- 32. Re-uire"/ +9plain the accounting treatment re,uired for the above machine and foreign currency contract, also preparing e9tracts from the financial statements /statement of comprehensive income and statement of financial position0 for the years ended 31 %arch 2611 and 31 %arch 2612. /2 mar<s0 /Adapted A""A *iploma in $#R 7une 2612 R4b0 Fuesti!n ' -eltec, a public limited company, processes and sells edible oils and uses several financial instruments to spread the ris< of fluctuation in the price of the edible oils. 'he entity operates in an environment !here the transactions are normally denominated in dollars. 'he functional currency of -eltec is the dollar. 'he entity uses for!ard and futures contracts to protect it against fluctuation in the price of edible oils. @here for!ards are used the company often ta<es delivery of the edible oil and sells it shortly after!ards. 'he contracts are constructed !ith future delivery in mind but the contracts also allo! net settlement in cash as an alternative. 'he net settlement is based on the change in the price of the oil since the start of the contract. -eltec uses the proceeds of a net settlement to purchase a different type of oil or purchase from a different supplier. @here futures are used these sometimes relate to edible oils of a different type and mar<et than those of -eltec>s o!n inventory of edible oil. 'he company intends to apply hedge accounting to these contracts in order to protect itself from earnings volatility. -eltec has also entered into a long?term arrangement to buy oil from a foreign entity !hose currency is the dinar. 'he commitment stipulates that the fi9ed purchase price !ill be denominated in pounds sterling. -eltec is unsure as to the nature of derivatives and hedge accounting techni,ues and has as<ed your advice on ho! the above financial instruments should be dealt !ith in the financial statements. Re-uire"/

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*iscuss the accounting principles involved in accounting for the above transaction and ho! the above transaction should be treated in the financial statement of -eltec. /14 mar<s0 /A""A (2 "orporate Reporting 7une 2616 R3/a00

11
11.1 11.2

)iscl!sure !# Financial Instruments

$#R- 4 #inancial $nstruments1 *isclosures provides the disclosure re,uirements for financial instruments. A summary of the re,uirements is detailed belo!. 'he t!o main categories of disclosures re,uired are1 /a0 information about the si,ni#icance of financial instruments. /b0 information about the nature an" e.tent !# ris5s arising from financial instruments. Si,ni#icance !# #inancial instruments

11 '

11.3.1 $#R- 4 re,uires disclosures for significance of financial instruments in the follo!ing aspects1 /a0 statement of financial positionD /b0 income statement and e,uityD and /c0 other disclosures. 11.3.2 $#R- 4 re,uires the carrying amounts for each of the follo!ing categories to be disclosed either on the face of the statement of financial position or in the notes1 /a0 financial assets at fair value through profit or lossD /b0 financial assets measured at amortised cost. /b0 financial liabilities at fair value through profit or lossD /c0 financial liabilities measured at amortised cost. 11.3.3 An entity must disclose items of income, e9pense, gains and losses !ith separate disclosure of gains and losses from each class of financial instrument. 11 8 Nature an" e.tent !# ris5s arisin, #r!m #inancial instruments

11.4.1 Rualitative disclosures L it describe1 /a0 ris< e9posures for each type of financial instrument /b0 management>s ob:ectives, policies, and processes for managing those ris<s /c0 changes from the prior period

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11.4.2 Ruantitative disclosures L this disclosures provide information about the e9tent to !hich the entity is e9posed to ris<, based on information provided internally to the entity>s <ey management personnel. 'hese disclosures include1 /a0 summary ,uantitative data about e9posure to each ris< at the reporting date /b0 disclosure about credit ris<, li,uidity ris<, and mar<et ris< as further described belo!. /c0 concentrations of ris<. 11 > T+pes !# ris5s

11.5.1 9ar5et ris5 L 'his refers to the possibility that the value of an asset might go up or do!n. 'here are three types of mar<et ris<1 currency ris<, interest rate ris< and price ris<. /a0 Currenc+ ris5 is the ris< that the value of a financial instrument !ill fluctuate due to changes in foreign e9change rates. /b0 #air value interest rate ris5 is the ris< that the value of a financial instrument !ill fluctuate due to changes in mar<et interest rates. /c0 $rice ris5 refers to other factors affecting price changes. 'hese can be specific to the enterprise /bad financial results !ill cause a share price to fall0, relate to the sector as a !hole /all 'ech?-toc<s boomed in the late nineties, and crashed in the ne! century0 or relate to the type of security /bonds do !ell !hen shares are doing badly, and vice versa0. 11.5.2 Cre"it ris5 is the ris< that one party to a financial instrument !ill fail to discharge an obligation and cause the other party to incur a financial loss. #or e9ample, a ban< is e9posed to credit ris< on its loans, because a borro!er might default on its loan. 11.5.3 Li-ui"it+ ris5 /funding ris<0 is the ris< that an enterprise !ill encounter difficulty in raising funds to meet commitments associated !ith financial instruments. #or e9ample, a business may be unable to repay its loans !hen they fall due. 11.5.4 Cash #l!6 interest rate ris5 is the ris< that future cash flo!s associated !ith a monetary financial instrument !ill fluctuate in amount due to changes in mar<et interest rates. $n the case of a floating rate debt instrument, for e9ample, such fluctuations result in a change in the effective interest rate of the financial instrument, usually !ithout a corresponding change in its fair value.

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