ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 11: Financial instruments
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currency of the parent company, not the presentational currency of the parent 9if
this is different).
The hedging instrument may be held within any entity in the group provided
that the conditions for hedge accounting are met in terms of the designation,
documentation and effectiveness of hedging requirements of IAS39.
When a foreign subsidiary is disposed of and hedge accounting has been used,
the amount reclassified from the foreign translation reserve (‘equity’) to profit or
loss should be the cumulative gain or loss on the hedging instrument.
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IAS 32: Presentation
Liability or equity?
Compound instruments
Other presentation issues
4 IAS 32: Presentation
4.1 Liability or equity?
Financial instruments issued by a company must be classified as either liabilities or
equity. This classification should be based on the substance of the contract, rather
than the legal form.
A financial liability is any liability where the issuer has a contractual obligation:
to deliver cash or another financial asset to another entity, or
to exchange financial instruments with another entity on potentially
unfavourable terms.
The owner of an equity instrument is entitled to receive a dividend, but the
company does not have a contractual obligation to make the payment. So equity
does not meet the above definition of a financial liability.
An equity instrument is defined as any contract that offers the residual interest in
the assets of the company after deducting all of the liabilities.
Returns on financial instruments
Returns on financial instruments are reported differently, depending on whether the
instrument is a liability or equity. The classification of the financial instrument
determines the treatment of the interest, dividends, gains and losses.
Interest expense, dividend payments, gains and losses relating to a financial
liability are recognised in the income statement.
Distributions to equity holders are debited to equity and shown in the
statement of changes in equity.
Example
Given the definitions above, how would preference shares and their dividend
payments most likely to be classified, and why?
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Answer
Preference shares must be classified as either equity or debt, according to their
substance. Most preference shares are closer in substance to debt as they have the
following characteristics:
a fixed dividend
no rights to participate in any surplus on winding up the entity.
The return on a preference share must be classified as dividends or interest in
accordance with the classification of the instrument. Hence the dividend payments
on most preference shares will be disclosed as interest expense in profit and loss.
4.2 Compound instruments
A compound instrument is a financial instrument, issued by a company that cannot
be classified as simply a liability or as equity, because it contains elements of both
debt and equity. An example of a compound instrument is a convertible bond. The
company issues a bond that can be converted into equity in the future or redeemed
for cash. Initially, it is a liability, but it has a call option on the company’s equity
embedded within it.
Typically, a convertible bond pays a rate of interest that is lower than the market
rate for a non-convertible bond (a ‘straight bond’) with the same risk profile. This is
because the terms of the conversion normally allow the bondholder to convert the
bond into shares at a rate that is lower than the market price.
Split accounting for compound instruments
On initial recognition of compound instrument, the credit entry for the financial
instrument must be split into the two component parts, equity and liability.
To do this, the following steps are necessary:
(1) Step 1. Derive the fair value of the liability
(2) Step 2. Calculate the equity component as the difference between the total
amount for the instrument and the fair value of the liability.
(3) Any transaction costs incurred by issuing the instrument should be allocated
to each component, the liability and equity, according to the split in value
above.
Example
A company issues a convertible bond. The details are as follows:
Numberofbondsissued 2,000
Nominalvalueperunit
$1,000
Annualinterestrate
5%
Marketrateatdateofissue
9%
Issuedate
1stJanuary20X5
Redemptiondates
31stDecember20X7
Termsofconversion
6$1sharesper$10nominalvalueofbond
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The cash proceeds of the issue are $2 million. (So debit Cash $2 million.)
The credit entry for the financial instrument must be split into its liability and equity
components. The process starts by deriving a fair value for the liability, on the
assumption that the bond has no conversion rights, and is a ‘straight’ fixed rate
bond that will be redeemed at par at maturity.
If the company had sold a bond with identical features but with no conversion
rights, how much could it have been sold for? To answer this question, it is
necessary to recognise that the fair value of a bond is simply the present value of the
future cash flows that the bond will generate, discounted at the market rate of
interest, which in this example is 9%.
31stDecember
Cash($)
Discountfactor
9%
Presentvalue
($)
20X5‐interest
100,000 0.9174
91,743
20X6‐interest 100,000 0.8417
84,168
20X7‐interest
100,000 0.7722
77,218
20X7‐principal
2,000,000 0.7722
1,544,367
Fairvalueofbond
1,797,496
Valueofequity(balance)
202,504
Proceedsfromissueofbond
2,000,000
On issue, the bond will therefore be recorded as follows:
$ $
DR Cash 2,000,000
CR Liability
1,797,496
CR Equity‐optionproceeds
202,504
As a financial instrument, the liability element of the bond to an entity that holds the
bond (the investing entity) must be classified as either ‘financial liability at fair value
through profit or loss’ or ‘financial liability measured at amortised cost’. IAS 39
restricts which financial liabilities can be designated as ‘fair value through profit or
loss’.
This classification is not allowed for an entity’s own issued debt. Therefore, the
financial liability for the entity that issued the bond must be classed as a ‘financial
liability measured at amortised cost’ - and carried at amortised cost in the statement
of financial position.
Under the amortised cost model the value of the liability element in the statement of
financial position each year is as follows:
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Brought
forward
9%effective
interest
Interest:cash
payment
Carriedforward
$ $ $ $
20X5 1,797,496 161,775 (100,000) 1,859,271
20X6
1,859,271 167,334 (100,000) 1,926,605
20X7
1,926,605 173,395 (100,000) 2,000,000
If all the bond holders convert on 31st December 20X7:
1,200,000 new shares will be issued ($2,000,000 nominal value of the bonds × 6
shares per $10 of bonds)
The nominal value of the shares will be $1,200,000 (1,200,000 shares at $1).
$ $
DR
Bond 2,000,000
DR Equity‐optionproceeds 202,504
CR
Sharecapital
1,200,000
CR
Sharepremium
1,002,504
4.3 Other presentation issues
Transactions in own equity
When a company whose shares are traded on the stock market buys back some of
its shares, they are called ‘treasury shares’. The company might then hold on to the
shares until it uses them for a particular purpose, such as awarding shares to
employees in a share grant scheme. The accounting treatment of treasury shares is
that they should be deducted from equity. Any gain or loss on such transactions are
other comprehensive income and should be taken directly to equity, and should not
be reported in profit and loss.
IAS 32 requires that the amount of treasury shares held should be disclosed
separately, either:
on the face of the statement of financial position as a deduction from share
capital, or
offset against share capital and disclosed in the notes to the accounts.
Offsetting
A financial asset and a financial liability may be offset and shown net in the
statement of financial position when and only when two conditions are met.
Condition 1: The company has a legal right to set off the amounts.
Condition 2: The company intends either to settle the amounts net, or to sell the
asset and use the proceeds to immediately settle the liability.
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In the past, companies were able to offset a credit balance and overdraft balance
with the same bank where they have the bank’s permission (legal right). This allows
them then to disclose only the net position (asset or liability) in the statement of
financial position.
The inclusion of Condition 2 in IAS 39 put an end to this practice of offsetting.
Simply having a legal right to set off a cash balance in one account with an overdraft
in another is insufficient for offsetting to be allowed. The company must
additionally show intent to settle the balances net, and this is likely to be rare in
practice. Consequently, cash balances in the bank and bank overdrafts will probably
be reported separately in the statement of financial position, and will not be ‘netted
off’ against each other.
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IFRS 7: Disclosure
Objectives of IFRS 7
Significance of financial instruments for financial position and performance
Nature and extent of risks arising from financial instruments
Discussion Paper: Reducing Complexity in Reporting Financial Instruments
5 IFRS 7: Disclosure
5.1 Objectives of IFRS 7
All companies are exposed to various types of financial risk. Some risks are obvious
from looking at the statement of financial position. For example, a loan requiring
repayment in the next year is reported as a current liability, and users of the
financial statements can assess the risk that the company will be unable to repay the
loan.
However, there are often many other risks that a company faces that are not
apparent from the financial statements. For example if a significant volume of a
company’s sales are made overseas, there is exposure to the risk of exchange rate
movements.
Example
A UK company has an investment of units purchased in a German company’s
floating rate silver-linked bond. The bond pays interest on the capital, and part of
the interest payment represents bonus interest linked to movements in the price of
silver.
There are several financial risks that this company faces with respect to this
investment.
It is a floating rate bond. So if market interest rates for bonds decrease, the
interest income from the bonds will fall.
Interest is paid in euros. For a UK company there is a foreign exchange risk
associated with changes in the value of the euro. If the euro falls in value against
the British pound, the value of the income to a UK investor will fall.
A bonus is linked to movements in the price of silver. So there is exposure to
changes in the price of silver.
There is default risk. The German company may default on payments of interest
or on repayment of the principal when the bond reaches its redemption date.
IFRS 7 requires that an entity should disclose information that enables users of the
financial statements to ‘evaluate the significance of financial instruments’ for the
entity’s financial position and financial performance.
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There are two main parts to IFRS 7:
A section on the disclosure of ‘the significance of financial instruments’ for the
entity’s financial position and financial performance
A section on disclosures of the nature and extent of risks arising from financial
instruments.
5.2 Significance of financial instruments for financial position and
performance
Statement of financial position disclosures
The carrying amounts of financial instruments must be shown, either in the
statement of financial position or in a note to the financial statements, for each class
of financial instrument:
Financial assets at fair value through profit or loss
Held-to-maturity investments
Loans and receivables
Available-for-sale financial assets
Financial liabilities at fair value through profit or loss
Financial liabilities measured at amortised cost.
Other disclosures relating to the statement of financial position are also required.
These include the following:
Collateral. A note should disclose the amount of financial assets that the entity
has pledged as collateral for liabilities or contingent liabilities.
Allowance account for credit losses. When financial assets (such as trade
receivables) are impaired by credit losses and the impairment is recorded in a
separate account (such as an allowance account for irrecoverable trade
receivables), the entity should provide a reconciliation of changes in the account
during the period, for each class of financial assets.
Defaults and breaches. For loans payable, the entity should disclose details of
any defaults during the period in the loan payments, or any other breaches in
the loan conditions.
Statement of comprehensive income disclosures
An entity must disclose the following items either I the statement of comprehensive
income or in notes to the financial statements:
Net gains or losses on financial assets or financial liabilities at fair value through
profit or loss.
Net gains or losses on available-for-sale financial assets, showing separately:
− The gain or loss recognised in other comprehensive income (and so directly
in equity) during the period, and
− The amount removed from equity and reclassified from equity to profit and
loss (the income statement) in the period.
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Net gains or losses on held-to-maturity investments.
Net gains or losses on loans and receivables.
Net gains or losses on financial liabilities measured at amortised cost.
Total interest income and total interest expense, calculated using the effective
interest method, for financial assets or liabilities that are not at fair value through
profit or loss.
Fee income and expenses arising from financial assets or liabilities that are not at
fair value through profit or loss.
The amount of any impairment loss for each class of financial asset.
Other disclosures
IFRS 7 also requires other disclosures. These include the following:
Information relating to hedge accounting, for cash flow hedges, fair value
hedges and hedges of net investments in foreign operations. The disclosures
should include a description of each type of hedge, a description of the financial
instruments designated as hedging instruments and their fair values at the
reporting date, and the nature of the risks being hedged.
With some exceptions, for each class of financial asset and financial liability, an
entity must disclose the fair value of the assets or liabilities in a way that permits
the fair value to be compared with the carrying amount for that class. (An
important exception is where the carrying amount is a reasonable approximation
of fair value, which should normally be the case for short-term receivables and
payables.)
5.3 Nature and extent of risks arising from financial instruments
IFRS 7 also requires that an entity should disclose information that enables users of
its financial statements to evaluate the nature and extent of the risks arising from its
financial instruments.
These risks typically include, but are not restricted to:
credit risk
liquidity risk, and
market risk.
For each category of risk, the entity should provide both quantitative and
qualitative information about the risks.
Qualitative disclosures. For each type of risk, there should be disclosures of the
exposures to risk and how they arise; and the objectives policies and processes
for managing the risk and the methods used to measure the risk.
Quantitative disclosures. For each type of risk, the entity should also disclose
summary quantitative data about its exposures at the end of the reporting
period. This disclosure should be based on information presented to the entity’s
senior management, such as the board of directors or chief executive officer.
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Credit risk
Credit risk is the risk that someone who owes money (a trade receivable, a
borrower, a bond issuer, and so on) will not pay. An entity is required to disclose
the following information about credit risk exposures:
A best estimate of the entity’s maximum exposure to credit risk at the end of the
reporting period and a description of any collateral held.
For each class of financial assets, a disclosure of assets where payment is ‘past
due’ or the asset has been impaired.
Liquidity risk
Liquidity risk is the risk that the entity will not have access to sufficient cash to meet
its payment obligations when these are due. IFRS 7 requires disclosure of:
A maturity analysis for financial liabilities, showing when the contractual
liabilities fall due for payment
A description of how the entity manages the liquidity risk that arises from this
maturity profile of payments.
Market risk
Market risk is the risk of losses that might occur from changes in the value of
financial instruments due to changes in:
exchange rates,
interest rates, or
market prices.
An entity should provide a sensitivity analysis for each type of market risk to which
it is exposed at the end of the reporting period. The sensitivity analysis should show
how profit or loss would have been affected by a change in the market risk variable
(interest rate, exchange rate, market price of an item) that might have been
reasonably possible at that date.
Alternatively, an entity can provide sensitivity analysis in a different form, where it
uses a different model for analysis of sensitivity, such as a value at risk (VaR)
model. (These models are commonly used by banks.)