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What are financial instruments?
- A financial instrument is any contract that gives rise to both a financial instrument asset of one entity and a financial liability or equity instrument of another
- Holder classifies financial instrument as asset
- Issuer classifies as liability/equity
Issuer: Debt vs Equity instruments
- Issuer of instruments determines if recognised as a liability or equity eg. preference shares.
- In some cases, some may be part debt and part equity. Eg. convertible notes
- All other things equal, managers prefer to disclose financial instruments as equity rather than debt.
- Reduce leverage ratio
- Dividends rather than interest expense
- APRA capital adequacy requirement
- Critical questions:
- Is there a contractual obligation?
- Where does the residual risk lie?
Primary vs Derivative financial instruments
- Primary: value is determined directly by markets eg. share
- Derivative: derives its value from the value of some other financial asset or variable eg. share option derives its value from the value of a share
- Key aspects of derivatives:
- Contracts between buyers and sellers.
- Derivative value rises and falls in accordance with the value of the underlying asset.
- Payoff is often determined or made at the expiration date.
- Sometimes no money is exchanged at the beginning of the contract.
Simple vs Compound financial instruments
- Simple: consists of a single financial asset, financial liability or equity instrument eg. loan receivable, loan payable, ordinary share
- Compound: consists of a combination of
- characteristics of financial assets, financial liabilities and equity instruments.
- From an issuer viewpoint, a compound instrument is a financial instrument that contains both a liability and an equity element. E.g., Convertible notes
- -Debt and equity components to be accounted for and disclosed separately
- -Fair value of whole instrument - Fair value of the liability component estimated using PV measurement = Equity component (residual)
- Debt giving the holder the right to convert securities into the issuer's ordinary shares.
- From the issuer's perspective, convertible notes have two components:
- -Liability: an agreement to deliver cash
- Equity: an option granting the holder the right for a specified period to convert the security into ordinary shares in the issuer.
- Standard AASB 132" classification for convertible notes is not revised as a result of a change in likelihood that the option will be exercised'
- This does not fit in with CF.
Initial account record
- Dr Bank
- Cr Convertible notes liability (PV of annual interest payments + PV of principal payment)
- Cr Convertible note option (the residual of the first two)
Subsequent record for convertible notes
(To record interest expense and coupon payment)
- Dr interest expense (using market interest rate)
- Cr Bank (principal payment)
- Cr Convertible notes liability
- Continues each year until maturity or until holders exercise the right to convert the liability to shares
Account entries when convertible notes are converted at maturity dates
- Dr Interest Expense
- Cr Bank
- Cr Convertible notes liability
- (Year payment entries)
- Dr Convertible notes liability (Full initial amount)
- Dr Convertible notes option (equity)
- Cr Share capital
- (To record conversion at maturity)
Convertible notes record accounts: no conversion
- Dr Interest expense
- Cr bank
- Cr convertible notes liability
- (to record interest expense and coupon payment)
- Dr Convertible notes liability
- Cr Bank (repay initial amount)
- Dr Convertible notes options (equity)
- Cr Retained earnings
- (to record the redemption of notes due to non-conversion at maturity)
Recognition and measurement of financial instruments AASB 9
- Will be used next year
- Financial instruments are recognised in the statement of financial position at the point of time when the entity becomes party to the contractual provisions of the instrument
- Generally at initial recognition financial instruments are measured at fair value
- Fair value “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (IFRS 13/AASB 13, Para. 9)
Foreign currency transactions: two general issues
- Where debts, receivables or other monetary items are denominated in currencies other than domestic currency there is a need to convert them into a single currency.
- Where an entity controls a foreign subsidiary, the accounts of that subsidiary need to be translated into a common currency before the consolidation process (not covered in this unit).
Define exchange rate, spot rate, closing rate, foreign currency
- Exchange rate: is the ratio of exchange for two currencies.
- Spot rate: is the exchange rate for immediate delivery.
- Closing rate: is the spot exchange rate at the reporting date.
- Foreign currency: is a currency other than the functional currency of the entity.
Functional vs presentation currencies
- Functional: The primary economic environment in which the entity operates. i.e. generates and expends cash.
- The currency in which funds from operating activities are generated
- Presentation: The currency in which the entity reports its financial statements. This is Australian dollars for the great majority of Australian companies.
Measurement and recognition of foreign currency transactions
Foreign currency transaction shall be recorded on initial
recognition in the functional currency
, translated at the spot rate at date of transaction.
- What happens at settlement?
- The spot rate at the date of settlement is used to translate the amount of foreign currency (monetary assets or liabilities) received/payable.
- The difference between initial and later measurement is recognised as an exchange gain or loss in profit and loss
What measurement is used when a balance date intervenes between initial and settlement date? Foreign currency transactions
- The asset/liability is measured again at settlement date.
- The amount of the monetary item is measured at the spot rate at balance date (the closing rate). The difference is recognised as an exchange gain or loss in profit and loss.
Long term receivables ad payables
- At balance date all monetary items must be translated using the reporting-date spot rates
- Exchange gain or loss that results from translating both current and non-current receivables and payables must be included in the operating profit or loss for the financial period
- Unpopular with Australian companies as fluctuations mean there is doubt as to whether unrealised profit/loss will actually be realised, particularly in relation to non-current monetary items
- Argued that recognition of a profit or loss at reporting date is inappropriate, since the exchange rate fluctuates in the long term and there is significant doubt whether the unrealised profit or loss will ever be realised