LECTURE 9

1. LECTURE 9 FINANCIAL INSTRUMENTS FRS 7 (IFRS 7): DISCLOSURE FRS 132 (IAS 32): PRESENTATION FRS 139 (IAS 39): RECOGNITION AND MEASUREMENT

2. INTRODUCTION:FINANCIAL INSTRUMENTS FRS Overview: FRS 7 Financial Instrument Disclosure: Issue – Part of IASB improvement project Detailing Financial Instruments DISCLOSURE,incorporate IAS 32 original disclosures req. + add. quantitative & qualitative disclosures on risks assoc. with finl. Instru. Effective date 1/1/2010 FRS 132 Financial Instrument Presentation: Amended in Feb. 2008 to specifically focus on the PRESENTATION of financial instrument, Initially was an IASC financial instruments project which began in 1988 until the std issuance in 1995 that dealt with issues on disclosures and presentations of financial instruments. Effective date 1/1/2010 FRS 139 Financial Instrument Recognition and Measurement: IASC financial instrument project, First issued on 1998 to address finl. instru RECOGNITION AND MEASUREMENT, Revised in 2000, Latest amendment August 2005. Effective date 1/1/2010

3. Financial Instruments – The Concern • Information availability? • Encompass Financial assets, financial liabilities, equity instruments and derivatives • E.g: Interest rate swaps, Treasury bond options, credit swaps, bonds, receivables, loans, shares etc • Have become > complex over the past 20 yrs – Cause difficulties in recognising, measuring, presenting and disclosing such instruments in finl report + lack of understanding of users of accounts of the significance of such instruments on entity’s finl perform, position and cash flows. (iv) WERE CARRIED OFF BALANCE SHEET. As a result user was unable to access the effect of these unless assisted by adequate disclosure and presentation. Potential of Misconduct? Using finl instru. entity can significantly change its financial risk profile ….reporting excessive gains or losses depending on whether instru prices move against or in favour of the entity

4. Continue…… (v) IASB noted Main problem – valuation of financial assets and liabilities at fair value…Presently IASB has not reached any conclusion about its imposition…Option given to preparer about its application…. IASB published discussion paper (March, 2008) ‘Reducing Complexity in Reporting Financial Instruments’…due to many ways measuring fin instruments. The discussion paper proposes, long- term solution to the complexity is to measure all financial instruments at FV BUTacknowledges there are issues and concerns to be addressed before IASB can require general FV measurement. 2 MAIN concerns: (i) Volatility of earnings arising from changes in FV (ii) Presentation of unrealised gains and losses in earnings Also, IASB will need to address further 4 issues wrt finl. instruments: (i) Presentation: How should the effects of changes in FV be presented in earnings? (ii) Disclosure: What info. about finl. instr. should be disclosed? (iii) Measurement: What is the def. of FV and how should FV be measured? (iv) Scope: What is the appropriate def of a finl. instru. and which finl instru., if any should be outside the scope of a std for finl. Instru.?

5. Continue… (B) Measurement Practice • Historical cost x necessarily provide the most relevant or consistent info for users. • Fair value identified give more relevant info about finl assets and liabilities. However where should unrealised gain or loss reported - P&L or Stat of Changes in Eq? Principally, gain recognised when it’s realised. This < relevance when entity trading underlying risks. Course of action….careful consideration given to information derived by measuring finl instru. at fair value + recognise gain or loss arising in P&L , compared with historical cost valuation (Norm …..Accountant reluctance to recognise unrealised gain or loss?)

6. FRS 132: Objective • To enhance financial statement users’ understanding of the significance of financial instruments to an entity’s financial position, performance and cash flows • Contains requirement for the presentation of finl instruments (and identifies info that should be disclosed by them). Presentation requirements apply to Classification of financial instruments, from the perspective of issuer into: (a) financial assets (b) financial liabilities (c) equity instruments Classification of related: (a) interest (b) dividends (c) losses (d) gains Circumstances in which financial assets and liabilities should be offset

7. FRS 132 & 139: Financial Instrument Definition: Any contract that gives rise to (i) a financial asset of one entity and (ii) a financial liabilityor equity instrument of another entity

8. FRS 132: Financial Asset DEFINITION: Any asset that is: • Cash • An equity instrument of another entity (e.g investment in Ord Shares) • A contractual right: (i) to receive cash or another financial asset from another entity, or (ii) to exchange financial instruments or financial liabilities with another entity under conditions that are potentially favourable to the entity (d) A contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own instruments or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the equity’s own equity instruments. (Similar to part (b) definition of financial liability) E.g: Trade receivables, loan receivable, investment in shares and bonds of another entity, investment in subsidiaries and bills receivable

9. FRS 132: Financial Liability DEFINITION : Any liability that is: • A contractual obligation (i) to deliver cash or another financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity (b) A contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own instruments or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the equity’s own equity instruments (Similar to part (d) definition of financial asset) E.g.: Trade payables, borrowings, debentures, bonds and redeemable preference shares Deferred revenue and most warranty obligations X financial liabilities as obligation to provide services or goods rather than to obligation to deliver cash; Income taxes X financial liability as no contractual obligation

10. FRS 132: Equity Instrument – Para 11 and 16 Definition: Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities E.g: Ordinary shares, preference shares, share options and warrants In the case issuer needs to determine a finl instru. is an equity instru or finl liab, the instrument, equity instru. if and only if: • The instrument includes x contractual obligation (i) to deliver cash or another financial asset to another entity or (ii) to exchange finl assets of finl liabilities with another entity under conditions that are potentially unfavourable to the issuer • If the instrument will or may be settled in the issuer’s own equity instruments, it is: (i) a non-derivative that includes X contractual obligation for the issuer to deliver variable number of its own equity instruments or (ii) a derivative that will or may be settled by the issuer exchanging a fixed amt of cash or another finl asset for a fixed no of its own equity instru. For this purpose the issuer’s own equity instruments do not include instruments that are themselves contract for the future receipt or delivery of the issuer’s own equity instru. A contractual obligat., including arising from a derivative finl instru., that will or may result in future receipt or delivery of the issuer’s own equity instru., but x meet conditions (a) and (b), is not equity instru.

11. FRS 132: Fair Value The amount for which an asset could be exchanged or a liability settled bet. knowledgeable, willing parties in an arm’s length transaction

12. Financial Instrument….Contract Financial Instrument is the contract, not the asset or liability. Thus needs to be clear what is meant by contract, contractual right and obligation. Para 13, FRS 132 identifies ‘contract’ and ‘contractual’ as an agreement between 2 or > parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually bec. the agreement is enforceable by law. Contracts, thus financial instruments, may take variety of forms and need not be in writing.

13. Exercise: Which of the following financial instruments? KEY POINT….Any of these items represents a contract? • Cash – • Gold bullion – • Debtors - • Creditors - • Loans- • Bank deposits- • Debentures- • A promissory note payable in govt bonds – • Ordinary shares – • Preference shares – • Plant and equipment previously bought and paid for by the entity – • Prepayments for goods and services – • Derivatives –

14. Continue… Derivatives: Para 9, FRS 139 A financial instrument or other contract within the scope of FRS 139 (i.e. Para 2-7) with all three of the following characteristics: (i) whose value changes in response to the change in a specified i/r, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar variable (underlying) (ii) that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions, and (iii) that is settled at future date * Contract that x give rise to finl instru. E.g: Operating lease for the use of physical asset – Can only be settled only by the receipt and delivery of services and thus x finl. Instru. Note from Exe. : Difficult to identify finl. instrument: Std uses the terms financial instrument, financial asset and financial liabilities rather loosely

15. Exercise 2: Are the following contracts finl instru? • Entity A enters both derivatives and an interest rate swap with another, B, that requires A to pay a fixed rate of 7% and receive a variable amt based on 3-mth LIBOR (London Interbank Offered Rate). The notional amt of the swap is Euro 1 Mil but this amt is not exchanged. A pays or receives a net cash amt each quarter based on the difference bet 7% and LIBOR 2. A also enters into a pay fixed, receive variable interest swap with C. The notional amt is for Euro 100 Mil and fixed rate of 10%. The variable rate based on 3-mth LIBOR. A prepays its fixed interest rate obligation as 100 Mil x 10% x 5 yrs discounted at market interest rates at the inception of the swap 3. A enters a contract to pay 10 Mil if D shares increase by 5% or more during 6-mth period and to receive 10 Mil if the share price decreases by 5% or more in the same period. No payment is made if the price movement is < 5% up or down.

16. FRS 132: Presentation of Liabilities and Equity Para 15: Issuer of finl instrument shall classify the instru or its component parts, on initial recog. as a finl. liability, finl asset or equity instrument in accordance with the substance of the contractual arrangement (x merely their legal form) and definitions of a finl liab, finl asset and equity instru. Substance Vs Legal Form (i) Finl liab- Its defining characteristic is there is a contractual obliga. on 1 party to deliver cash or finl asset or exchange finl asset or finl liab in terms that unfavourable to the issuer *Finl instru is finl liability if obligation exists irrespective of the manner it is settled whether issuer may or x fulfill the obligat. * When issuer has obligat to purchase its own shares for cash or finl asset, there is liab. for the amt. (e.g. Present Value of the redemption amt) that the issuer obliged to pay

17. Continue….Para 17-24 (ii) Equity Instrument – *Obligation to deliver cash or another finl asset or to exchange finl instru. on potentially unfavourable terms X exist. *Issuer x have contractual obligat. to distribute dividends, that instru that entitles holders to such dividend is equity Most of the times substance and form go hand in hand Exceptions: • Preference shares – Redeemable preference shares Preference shares redeemable for a fixed amt at a pre-determined future date is finl liab • Non redeemable preference shares Classification determined by other rights attached to them and to be based on an assessment of the substance of the contractual arrangements and def. of finl liab and equity instru. If dividends whether cumulative or non-cumulative at issuer discretion, the instru is equity • Puttable instruments Finl instru that gives holder right to return instru to issuer for cash or another finl asset (a ‘puttable instru’) is finl. liab. E.g Puttable instruments that gives holders to return instru to issuer are unit trusts, open-ended mutual funds, ownership units in co-operatives

18. Puttable Instruments: Financial Liab Vs Equity Under these conditions, the puttable instruments will be cllsified as equity rather than finl liability, when: • It entitles the holder to a pro-rata share of the entity’s net assets in the event of liquidation • It is subordinate to all other classes of instruments, i.e. it has no priority under liquidation before others and it does not need to be converted into another instru before it is subordinate • In subordinate class all instruments have identical features • It does not include obligation to deliver cash or another finl asset except for the redemption • Its cash flows are based substantially on P&L attained

19. Example 1 Z has 2 classes of shares, founder shares and investor shares. The fund has issued 1000 founder shares with par value of $1 which are held for regulatory purposes. The founder shares are not redeemable, carry voting rights but are x entitled to dividends. The investor shares issued are 900,000 with par value of 1 cent each, they are redeemable at fair value at the option of the holder, carry x voting rights, but entitled to dividends. In the case of liquidation the founder shares rank equally with investor shares with each entitled to amt equal to its par value. The investor shares are entitled to any surplus after payment of par values. Which if any of the shares is equity?

20. Answer Investor shares x equity as x form part of the subordinate class of instru. The founder shares are the most subordinate as x gain any of the surplus nor do investor shares have same features as founder shares. If however the founder shares is repurchased by Z then the investor shares would be reclassified as equity. Founder shares are equity as x puttable, they are subordinate and there is x obligation on the entity to deliver cash or other finl assets to holder.

21. Homework • Questions 30.1 and 30.2 pg. 416 Lazar et al, Financial Reporting Stds for Malaysia, 2nd ed.