Chapter 15
Accounting for
financial instruments
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-1
Learning objectives
• Understand what a financial instrument is
• Be able to describe various types of financial
instruments
• Understand the difference between a primary
financial instrument and a derivative financial
instrument
• Understand that some derivative financial
instruments can significantly increase the risk
exposure of an organisation, and so appreciate
the necessity for full disclosure in relation to such
instruments
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-2
Learning objectives (cont.)
• Understand what a compound financial
instrument is and how the debt and equity components
of a compound equity instrument are to be determined
• Understand the requirements of AASB 7
- ‘Financial Instruments: Disclosure’; AASB 132
- ‘Financial Instruments: Presentation’ and AASB 139
- ‘Financial Instruments: Recognition and
Measurement’
• Be able to provide accounting entries for various types
of futures contracts, options, swap agreements and
compound financial instruments
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PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-3
Relevant accounting standards
There are three standards:
1. AASB 7 ‘Financial Instruments: Disclosure’
2. AASB 132 ‘Financial Instruments: Presentation’; and
3. AASB 139 ‘Financial Instruments: Recognition and
Measurement’
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-4
Financial instruments defined
• A financial instrument (AASB 132) is
– any contract that gives rise to both a financial asset of
one entity and a financial liability or equity instrument of
another entity
• A financial asset (AASB 132) is
– cash; or
– a contractual right to receive cash or another financial
asset from another entity; or
– a contractual right to exchange financial instruments
with another entity under conditions that are potentially
favourable; or
– an equity instrument of another entity
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
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15-5
Financial instruments defined (cont.)
• A financial liability (AASB 132) is
– any liability that is a contractual obligation
 to deliver cash or another financial asset to another entity;
or
 to exchange financial assets or liabilities with another
entity under conditions that are potentially unfavourable; or
– a contract that is a derivative; or
– a non-derivative
• An equity instrument (AASB 132) is
– any contract that evidences a residual interest in the
assets of another entity after deduction of all its liabilities
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-6
Financial instruments defined (cont.)
• Central to the definition is whether or not a
‘contractual obligation’ exists
– if there is no contractual obligation to deliver cash or
another financial asset, or to exchange another financial
instrument under conditions that are potentially
unfavourable, it is considered to be an equity
instrument
– what does ‘unfavourable’ mean in this context? – see
Worked Example 15.1 (p. 507) which shows how the
issue of share options creates a financial asset in the
accounts of the holder of the options, and a financial
liability in the accounts of the issuer
– in the context of the issue of options, the likelihood of
the option being exercised does not impact on its
classification as a financial liability
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-7
Financial instruments defined (cont.)
• Examples of financial instruments
–
–
–
–
–
–
–
–
cash at bank
bank overdrafts
term deposits
trade receivables and payables
investments
options
forward foreign exchange agreements
foreign currency swaps
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-8
Financial instruments defined (cont.)
• Primary financial instruments
– include receivables, payables and equity securities such
as ordinary shares – accounting treatment fairly
straightforward
• Derivative financial instruments
– create rights and obligations with the effect of
transferring one or more of the financial risks inherent in
an underlying primary financial instrument
– include financial options, futures, forward contracts and
interest rate and currency swaps
• Refer to Worked Example 15.2 (p. 510)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-9
Debt versus equity components of
financial instruments
• The issuer of a financial instrument must
determine whether to disclose it as a liability or
equity (AASB 132)
– they are required to consider economic substance
rather than just the legal form
• Critical feature in differentiating financial liability
from equity is the existence of a contractual
obligation on the part of one entity either to deliver
cash or another financial asset to, or to exchange
another financial instrument
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-10
Debt versus equity components of
financial instruments (cont.)
• Preference shares
– if there is an option to redeem the shares for cash,
should be debt rather than equity
– when distributions to shareholders are at the issuer’s
discretion, shares are equity
• If classified as debt, then periodic payments are
classified as interest expenses, which will affect
profits
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-11
Debt versus equity components of
financial instruments (cont.)
• Convertible notes
– debt giving the holder the right to convert securities into
the issuer’s ordinary shares
– often classified as compound financial instruments,
containing both a financial liability and equity component
– debt and equity components to be accounted for and
disclosed separately
• Interest can be treated as part of the cost of an
asset under construction
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-12
Debt versus equity components of
financial instruments (cont.)
• Instruments cannot be reclassified after initial
recognition unless
– their substance is altered by a transaction or other
specific action by the issuer (AASB 132)
• The AASB Framework allows reclassifications
based on revised probabilities (however,
accounting standards take precedence)
• Determine fair value of liability component and
equity component as the residual
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-13
Measurement of financial instruments
• According to AASB 139
– financial instruments are generally to be measured at
fair value, with some exceptions
• Categories of financial instruments (AASB 139)
– financial asset or financial liability at fair value through
profit and loss;
– held-to-maturity investments;
– loans and receivables;
– available-for-sale financial assets
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-14
Financial asset or financial liability at fair
value through profit or loss
• Financial asset or financial liability at fair value
through profit or loss if (AASB 139)
– classified as held for trading; or
– upon initial recognition it is designated by entity as at
fair value through profit or loss
– periodic adjustments go to profit or loss
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15-15
Available-for-sale financial assets
• Includes all financial assets that don’t fall into
other categories
• Equity investments to be measured at fair value
• Changes in fair value recognised in equity until
financial asset is derecognised
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15-16
Loans and receivables and
held-to-maturity investments
• To be measured at amortised cost using the
effective-interest method
• If an impairment loss has been incurred, amount
of loss is calculated as (AASB 139)
– the difference between asset’s carrying amount and
present value of estimated future cash flows with;
 carrying amount to be reduced directly or through an
allowance account
 loss to be recognised in profit or loss
Copyright  2007 McGraw-Hill Australia Pty Ltd
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15-17
Other financial liabilities
• To be recognised at amortised cost using
effective-interest method subsequent to initial
measurement (AASB 139)
• Refer to Worked Example 15.3 (p. 521)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-18
Derivative financial instruments
• Can include
–
–
–
–
–
futures contracts
options contracts
interest rate swaps
foreign currency swaps
forward-rate contracts
• To be recognised initially at fair value (AASB 139)
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-19
Derivatives used within a hedging
arrangement
•
•
Derivatives often used to hedge gains or losses in future in
relation to other assets or liabilities
Hedge contract
– arrangement with another party in which that party accepts
the risks associated with changing commodity prices or
exchange rates
•
Three principal types of hedges (AASB 139)
1. fair value hedges
2. cash-flow hedges
3. hedges of net investments in foreign operations
•
•
Need to differentiate between hedged item and hedging
instrument
Refer to Worked Example 15.4 (p. 522)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-20
Derivatives used within a hedging
arrangement (cont.)
• Fair value hedge
– used to hedge the value of particular assets or liabilities
• Cash-flow hedge
– used to hedge a future expected cash flow
• Unless certain strict requirements are satisfied
(AASB 139)
– any gain or loss on hedging instrument to be taken to
profit or loss
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-21
Derivatives used within a hedging
arrangement (cont.)
• Tests for hedge effectiveness
– at inception of hedge and throughout its life, hedge must
be ‘highly effective’
– as measured each financial period, hedge is deemed to
be highly effective so that actual results are between 80
and 125%
• Fair value hedge
– both hedged item and hedging instrument to be
measured at fair value
– any gains or losses to be included as part of profit or
loss
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-22
Derivatives used within a hedging
arrangement (cont.)
• Cash-flow hedge
– gain or loss on measuring hedged item at fair value is to
be part of period’s profit or loss
– gain or loss on hedging instrument initially transferred to
equity, then transferred to income statement to offset
gains or losses on hedged item
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-23
Futures contracts
• A contract to buy or sell an agreed quantity of a
particular item, at an agreed price, on a specific
date
• Buy or sell price determined on date contract
entered into
• First futures contracts introduced in 1960 in
Australia for greasy wool
• Majority of trading volume now relates to financial
futures
– result in the ultimate transfer of cash or another financial
instrument
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-24
Futures contracts (cont.)
• Financial futures currently traded
–
–
–
–
–
90-day bank bill futures
3-year bond futures
10-year bond futures
share price index futures (SPI futures)
futures for shares in specific companies
• Huge losses (or gains) can be made on the
futures market
• Refer to Worked Examples 15.5 and 15.6
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-25
Futures contracts (cont.)
• Share price index (SPI) futures
– based on e.g. market prices of top 200 companies and
on performance of top 50 companies
– directly related to the All Ordinaries SPI
– may be used for hedging purposes or speculation
• Refer to Worked Example 15.7 (p. 529)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-26
Journal entries for SPI futures
• To make a percentage deposit with the futures
broker
Debit
Deposit on SPI futures
Credit
Cash at bank
• To ‘mark to market’ the value of the organisation’s
share portfolio
Debit
•
Loss on share portfolio
Credit
Share portfolio
To credit gains to the initial deposit held by the
futures broker
Debit
Deposit held by broker
Credit
Gain on futures contract
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-27
Journal entries for SPI futures (cont.)
• If shares are sold and futures contract is closed
out
Debit
Debit
Cash
Loss on share portfolio
Credit
Share portfolio
Debit
Deposit held by broker
Credit
Gain on futures contract
Debit
Cash at bank
Credit
Deposit held by broker
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-28
Journal entries for currency futures
• Refer to Worked Example 15.8
• To record sale at spot rate
Debit
Debit
Accounts receivable
Cost of goods sold
Credit
Sales revenue
Credit
Inventory
• To record deposit made with futures broker
Debit
Deposit on futures contract
Credit
Cash at bank
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-29
Journal entries for currency futures
(cont.)
• To record receipt from overseas purchaser
Debit
Debit
Cash at bank
Loss on foreign exchange
Credit
Accounts receivable
• To record gain on futures contract
Debit
Deposit with futures broker
Credit
Gain on futures contract
(equity)
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-30
Journal entries for currency futures
(cont.)
• To transfer gain from equity to offset loss on
hedged item
Debit
Gain on futures contract (equity)
Credit
Gain on futures contract
(in profit or loss)
• To record receipt of original deposit and gains on
contract
Debit
Cash at bank
Credit
Deposit with futures broker
Copyright  2007 McGraw-Hill Australia Pty Ltd
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15-31
Options
• Put options
– give their holder the right to sell an asset, at a specified
exercise price, on or before a specified date
– value of option depends on market price of underlying
security
• Call options
– give their holder the right to buy an asset, at a specified
exercise price, on or before a specified date
Copyright  2007 McGraw-Hill Australia Pty Ltd
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15-32
Options (cont.)
• Exercise price
– the price the option holder will pay to buy a company’s
shares
• Once exercise price is determined, it remains
fixed, regardless of variations in market price of
shares
• When an option is acquired on the ASX, an
amount is paid for it
• The holder of the option has the right to exercise
the option, but typically does not have to do so
• Options are to measured at fair value, with
changes included as part of profit or loss
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-33
Journal entries for options
• Refer to Worked Example 15.9 (p. 535)
• To record investment in share options
Debit
Investment in share options
Credit
Cash at bank
• To value share options at fair value
Debit
Investment in share options
Credit
Profit on share options
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15-34
Swaps
• Swap agreement
– an agreement between borrowers to exchange
aspects of their respective loan obligations
• Commonly used swaps
– interest rate swaps
– foreign currency swaps
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15-35
Swaps (cont.)
• Foreign currency swaps
– obligation relating to a loan in one currency is swapped
for that of a loan in another currency
– used when entity has receivables and payables both
denominated in a different foreign currency
– used to hedge against effects of changes in exchange
rates
– entity seeks another entity that is prepared to swap its
foreign currency loans for the entity’s domestic loans
– primary borrower still has commitment to primary lender
should the other party to the swap default on the
arrangement
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
15-36
Journal entries for foreign currency
swaps
• Refer to Worked Examples 15.10 and 15.11
• To recognise initial loan received
Debit
Cash
Credit
Foreign loan
• To recognise the swap
Debit
Credit
Foreign currency receivable
Australian loan
• To recognise loss on the foreign loan
Debit
Credit
Foreign exchange loss
Foreign loan
• To recognise gain on the receivable
Debit
Credit
Foreign currency receivable
Foreign exchange gain
Copyright  2007 McGraw-Hill Australia Pty Ltd
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15-37
Journal entries for foreign currency
swaps (cont.)
• To recognise payment made to foreign company
Debit
Interest expense
Credit
Cash
• To recognise payment made to other company
Debit
Interest expense
Credit
Cash
• To recognise domestic loan taken out
Debit
Cash
Credit
Loan
• To recognise the swap
Debit
Loan receivable
Credit
Foreign currency payable
Copyright  2007 McGraw-Hill Australia Pty Ltd
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15-38
Journal entries for foreign currency
swaps (cont.)
• To recognise the loss on the foreign loan
Debit
Foreign exchange loss
Credit
Foreign currency payable
• To recognise interest payment on domestic loan
Debit
Interest expense
Credit
Cash
• To recognise adjustment to interest expense
Debit
Cash
Credit
Interest expense
Copyright  2007 McGraw-Hill Australia Pty Ltd
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15-39
Swaps (cont.)
• Interest rate swaps
– one party exchanges interest payments of a specified
amount with another party
– generally involves swapping variable or floating interest
rate payments for a fixed interest rate obligation
– for a swap to proceed both parties need to receive
benefits in the form of a reduction in total interest
payments
• Refer to Worked Example 15.12
Copyright  2007 McGraw-Hill Australia Pty Ltd
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15-40
Compound instruments
• Contain both a financial liability and an equity
component
• Include convertible notes
– similar to convertible bonds, except less formal in the
absence of a detailed deed
• AASB 132 requires
– equity component to be fair value of the whole
instrument less fair value of the liability component. That
is, the equity component is the residual measure
• The AASB Framework considers perceived
probabilities of conversion
– differently from AASB 132
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
15-41
Journal entries for compound
instruments
• Refer to Worked Example 15.13 (p. 542)
• To record the issue of the convertible bonds
Debit
Cash at bank
Credit
Convertible bonds (liability)
Credit
Convertible bonds (equity)
The liability component is determined by calculating the present value
of the future cash flows at the market’s required rate of return based
on “instruments of comparable credit status and providing
substantially the same cash flows, on the same terms, but without
the conversion option” (AASB 132)
• To recognise interest expense
Debit
Interest expense
Credit
Cash
Credit
Convertible bonds (liability)
Interest expense equals the present value of the opening liability
multiplied by the market rate if interest
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15-42
Journal entries for compound
instruments (cont.)
If option holders elect to convert options to ordinary
shares
• To recognise interest expense
Debit
Interest expense
Credit
Cash
Credit
Convertible bonds (liability)
• To recognise conversion of bonds into shares
Debit
Debit
Convertible bonds (liability)
Convertible bonds (equity)
Credit
Share capital
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15-43
Disclosure requirements
• Large number of detailed disclosure requirements
in AASB 7
– a direct consequence of large losses incurred by many
organisations
• Purpose of AASB 7’s disclosure requirements
– to enhance understanding of significance of financial
instruments; and
– to assist in assessing amounts, timing and certainty of
cash flows
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15-44
Disclosure requirements (cont.)
• Numerous disclosure requirements in AASB 7 – best
way to appreciate the extensive nature of the
disclosures is to review the standard
• Interesting to see that there are various disclosures
related the ‘risks’ associated with financial instruments
(par. 32 – 42)
• Risk to be disclosed relate to:
– credit risk (the risk that one party to a financial instrument will
cause a financial loss for the other party by failing to
discharge an obligation)
– liquidity risk (the risk that an entity will encounter difficulty in
meeting obligations associated with financial liabilities)
– market risk (the risk that the fair value or future cash flows of a
financial instrument will fluctuate because of changes in
market prices)
Copyright  2007 McGraw-Hill Australia Pty Ltd
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15-45
Summary
• The chapter addresses issues associated with financial
instruments
• ‘Financial instruments’ includes a wide range of items
– can be classified as primary or derivative
• AASB 7 provides many disclosure requirements for
financial instruments
• AASB 132 provides guidance for determining whether a
financial instrument is a financial liability or an equity
instrument
• AASB 139 provides requirements for recognition and
measurement of financial instruments
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15-46