Accounting for Financial Instruments

LO: Define financial instrument and distinguish between primary

and derivative financial instruments
Deregulation of financial markets from late 1970s, emergence and
trading of sophisticated financial instruments (eg, options to buy or
sell assets for a particular price);

- Enabled entities to raise funds;

- Assisted entities in the management of risks such as

changes in interest rates, currency exchange rates and market
prices of securities;

- Provide entities with off-balance-sheet financing

opportunities;

- Also fee income for financial institutions.

Accounting standard setters struggled to deal with financial
instruments
- High turnover of financial instruments; rapid changes in
value
- When used for off-balance-sheet financing, exposure to
financial instruments was not apparent in financial reports;

Accounting standard-setters began by seeking disclosures about

financial instruments, then tried to standardise accounting.
- Standard setters controversial idea was that financial
instruments
should be:
- recognised in financial statements;
- revalued regularly to fair value; and that
- Value changes be included as part of profit/loss.
Strong opposition from preparers of financial reports,
- Financial instruments were at the heart of the 2007/8 financial
crisis. The accounting standard for financial instruments changed
suddenly during the crisis, and has been changing further since
then.
A financial instrument is (AASB 132):
Any agreement that creates a financial asset of one entity and

a financial liability or equity instrument of another entity;

e.g. The sale of goods by one entity to another on credit will give
rise to:

- a financial asset for the seller (accounts receivable); and

- a financial liability for the purchaser (accounts payable)

Note a contract or contractual arrangement must exist; if

this is not present, then an item is not a financial instrument;

Excludes some but not all contracts for delivery of certain

commodities.

Financial asset (AASB 132):

- Cash

- An equity instrument of another entity

- A contractual right:
To receive cash or another financial asset; or
To exchange financial assets or financial liabilities under
potentially
favourable conditions; or

- A contract that will or may be settled in the entitys own

equity instruments and is:
A non-derivative for which the entity is or may be obliged
to receive a variable number of the entitys own equity
instruments; or
A derivative that will or may be settled other than by the
exchange of a fixed amount of cash or another financial asset

Financial liability (AASB 132): - A contractual obligation:

To deliver cash or another financial asset
To exchange financial assets or financial liabilities under
potentially
unfavourable conditions; or

- A contract that will or may be settled in the entitys own equity

instruments and is:
A non-derivative for which the entity is or may be obliged to
deliver a variable number of the entitys own equity instruments; or
A derivative that will or may be settled other than by the
exchange of a fixed amount of cash or another financial asset

Primary financial instruments:

- Financial assets: Such as cash, accounts receivable, notes

receivable, loans receivable

- Financial liabilities: Such as accounts payable, notes

payable, loans payable
Derivative (secondary) financial instruments:

- Derive their value from something else underlying the

financial instrument (eg share price or exchange rate)

- Create rights and obligations that have the effect of

transferring between the parties to the instrument one or
more of the financial risks inherent in an underlying primary
financial instrument. Examples: forward contracts, options,
interest rate or currency swaps

- All 3 characteristics must be met AASB 139: 9 (a) 9 (c)

A financial asset and a financial liability must be offset and the net
amount presented in the statement of financial position when, and
only when, an entity (AASB 132):

- Currently has a legally enforceable right to set off the

recognised amounts; and

- Intends either to settle on a net basis, or to realise the asset

and settle the liability simultaneously

LO: Identify the categories of financial assets and financial liabilities

in AASB 139 Financial Instruments:
Recognition and Measurement
AASB 139.9 classifies financial instruments into the following 4
categories:

1. 1. Financial asset or financial liability at fair value through

profit and loss (FVPL);
2. 2. Held-to-maturity asset investments (HTM);
3. 3. Loans and Receivables (LR);
4. 4. Available-for-sale financial assets (AFSFA).
Measurement under AASB 139
- Classification of financial instrument affects its measurement on
initial recognition and subsequently
Initial recognition: see AASB 139.43 Fair value
- Transaction costs are included in initial recognition of all categories
other than FVTPL
Financial assets or financial liabilities classified as fair value
through profit or loss (FVTPL) on initial recognition where:

- Acquired/incurred principally for selling or repurchasing in

the near term, or a derivative (except for a derivative
designated as an effective hedge) or part of portfolio of
identified financial instruments managed together and recent
actual pattern of short-term profit-taking

- Examples share investments held for short-term gains;

interest rate swaps; call options purchased for speculation;
speculative futures contracts
Accounting treatment:
- initial measurement: fair value
- subsequent measurement: at fair value
- gains and losses: recognised in profit or loss as part of the
comprehensive income statement

Non-derivative financial assets with fixed or determinable

payments, fixed maturity, and the entity has both the intention, and
the ability to hold to maturity
Examples: government & corporate bonds; convertible notes with
a fixed conversion date
Accounting treatment:
- Initial measurement: fair value plus transaction costs

- Subsequent measurement: amortised cost using the effective

interest rate method (AASB 139.9)
- If change in intention or ability to hold to maturity, reclassify
asset as AFS & remeasure at fair value. Recognise difference
between carrying amount and fair value in equity (OCI Other
comprehensive income)
- Transfer to profit & loss when asset sold
Non-derivative financial assets with fixed or determinable
payments, that are not quoted in an active market
Loans & receivables cannot be reclassified
Examples would be accounts receivable; loans to other
entities; mortgage loans of banks; credit card receivables
Accounting treatment:
- Initial measurement: fair value plus transaction costs
- Subsequent measurement: at amortised cost using the effective
interest rate method
Non-derivative financial assets designated as available-for- sale
(AFS) or not classified as FVTPL, HTM or L&R
- Examples: share or bond investments; investment in convertible
notes Accounting treatment
- Initial measurement: fair value plus transaction costs
- Subsequent measurement: fair value
- Gains and losses: recognised in equity (OCI) and transferred to
profit and loss when asset is sold

 Recognition and measurement of financial instruments has been

controversial.

- Standard-setters tried to require all financial instruments to

be measured and reported at fair value, to remeasure
(revalue) them every period and to include the changes in
value in the profit or loss for the period.

- That approach has been strongly opposed.

- The accounting for financial instruments has attracted

considerable news media commentary over the years

The result of the opposition to the standard-setters

preferred fair value measurement of all financial instruments,
with changes in value included in profit each year has been
the development of purpose-led classifications based on
management intent.
- Categories of financial instruments devised with different
accounting requirements for each category.
- 1. Amortised cost; 2. fair value through P&L; 3. fair value
through OCI - The recognition and measurement of a financial
instrument, and the
effect on the financial reports, differs depending on the
category

In the latest changes in AASB 9, the categories of financial

instruments are determined with reference to the entitys
business model.

The business model test relates to the entitys approach to

managing its financial assets (AASB 9 para 4.1.1)

an entity shall classify financial assets as subsequently

measured at either amortised cost or fair value on the basis of
both:

(a) the entitys business model for managing the financial

assets; and

(b) the contractual cash flow characteristics of the financial

asset

Applies only to debt instruments

A financial asset shall be measured at amortised cost if both
of the

following conditions are met:

(a) the asset is held within a business model whose objective

is to hold assets in order to collect contractual cash flows.

(b) the contractual terms of the financial asset give rise on

specified dates to cash flows that are solely payments of
principal and interest on the principal amount outstanding
(AASB 9 para 4.1.2)

At initial recognition these financial assets are measured at

fair value plus transaction costs directly attributable to
acquisition (AASB 9 para 5.1.1)

Subsequently, these financial assets are measured at

amortised cost (AASB 139 para 9 via AASB 9 para 5.2.1)

- Financial assets measured at fair value through profit and loss.

Applies to all financial assets unless otherwise classified
- Includes financial assets held for trading purposes and derivatives
- Initially measured at fair value (AASB 9 para 5.1.1)

- Subsequent to initial recognition, measured at fair value at each

reporting date, with changes in fair value included in calculating the
profit or loss for the reporting period (AASB 9 para 5.1.5)
Financial assets measured at fair value through other
comprehensive income:

- Applies to equity instruments that are not held for trading

and that are designated in this way on initial recognition
(AASB 9 para 5.7.5)

- On initial recognition measured at fair value plus transaction

costs (AASB 9 para 5.1.1)

- Subsequent to initial recognition, measured at fair value

with any changes in fair value recognised in other
comprehensive income (AASB 9 para 5.7.5)

1. Financial liabilities measured at fair value through profit and loss

- Applies to financial liabilities incurred for trading purposes

and
for derivatives that are not part of a hedging arrangement

- Initially recognised at fair value (AASB 9 para 5.1.1)

- Subsequently, measured at fair value each reporting period

with changes in fair value included in calculating the profit and
loss for each period (AASB 9 para 4.2.1(a))

2. Other financial liabilities

- Recognised initially at fair value plus transaction costs

(AASB 9
para 5.1.1)

- Subsequently measured at amortised cost using the

effective interest method (AASB 9 para 4.2.1)
Refer to Example 14.1 H&P pages 436-437

The standard setters have tried to require fair value through P&L for
all financial instruments.
The classifications mean that some financial instruments are
treated differently. This affects the amounts of financial assets and
liabilities reported in the statement of financial position, and the
reported financial results.
For some entities, the classifications make a big difference to their
financial reports.
Changing the classifications also changes the financial results for
example shifting financial instruments from FV though P&L to FV
through OCI or to Amortised cost.

- AASB 9, 132 & 139 definitions of fair value all refer to AASB
13 Fair value measurement

- Apply the AASB 13 fair value hierarchy to financial

instruments in the following order:
- Level 1: quoted prices in an active market, most reliable
evidence (AASB 9 paras 76- 80)
o - Level 2: values other than quoted prices e.g. prices of
similar assets in an active market (AASB 9 pars 81-85)
o - Level 3: unobservable inputs e.g. DCF; or option
pricing models (AASB 9 paras 86-90)

LO: As an example of a derivative financial instrument, understand

the nature of swaps and explain how to account for them
A Financial instruments may be used for: - Trading purposes (ie.
speculative); or
- Hedging (often to manage risks)
A hedging arrangement involves taking a position opposite to the
original transaction so the entity minimizes its exposure to gains
and losses on particular assets and liabilities.
A hedge uses a derivative instrument to manage the risk of losses
from holding or realising the underlying asset or liability. It does so
by designating a hedging instrument (the derivative) linked to a
hedged item (the underlying asset or liability).

 Hedge accounting recognises the offsetting effects on profit or loss

of changes in the fair values of the hedging instrument and the
hedged item (AASB139.85)
To be eligible for hedge accounting this hedging relationship
(between the instrument and the item) must satisfy certain
conditions (AASB 139.88):

At inception of the hedge there is a formal designation and

documentation of the hedging relationship and the entitys
risk management objective and strategy for undertaking the
hedge eg, like Qantas 2013 Annual Report Note 35.

The hedge is expected to be highly effective this is very

complex and you are not expected to be able to calculate
effectiveness [AASB 139.AG105- AG113] in ACCT2011.

For cash flow hedges any forecast must be highly probable

and affect profit or loss

Effectiveness of the hedge can be measured reliably

The hedge is assessed continuously to determine actual

effectiveness

The types of hedging relationships are:

Fair value hedges (FVH) ie, hedging the changes in the fair
value of a financial asset or financial liability the hedged item eg,
the price of jet fuel
Cash flow hedges (CFH) ie, hedging changes in the cash flows
related to the financial asset or financial liability the hedged item
eg, changes in the cash flows associated with variable interest
rates.
Net investment of foreign operations hedges eg, multinational
groups [this is not covered in ACCT2011]
Essentially the differences in the accounting between FVH and CFH
are that:
For FVH all the changes go through profit or loss;
For CFH the effective portion is booked to OCI with subsequent
reclassification to profit or loss and the ineffective portion is booked
immediately to profit or loss.

 Swaps are:
- Agreements in which two counterparties undertake to exchange a
series of future cash flows
Major types of swaps: - Interest rate swap:
- An agreement between two parties to exchange interest payments
for a specific period, related to an agreed principal amount
- Currency swap:
- Future cash flows calculated using an interest rate in one currency
are swapped for future cash flows calculated using an interest rate
in another currency

LO: Understand the purpose of and identify the main disclosure

requirements in AASB 7 and AASB 132
AASB 7 requires disclosure of information to enable users of
financial report to evaluate the:

- the significance of financial instruments to an entitys

financial position and performance

- The nature and extent of risks arising from financial

instruments to which the entity is exposed at reporting date
and how the entity manages those risks

- Disclosure of accounting policies, the recognition criteria

and the basis of measurement; and

- Other disclosures which include exposure to liquidity risk,

credit risk, market risk, risk management policy, and the fair
value for each class of financial asset and financial liability
and how this is determined

AASB 7 requires disclosure of information to assess the fiar value.

The fair value hierarchy introduces 3 levels of inputs based on the
lowest level of input significant to the overall fair value (AASB 7. 27A
27B)
- Level 1 quoted prices for similar instruments
- Level 2 directly observable market inputs other than level 1
inputs - Level 3 inputs not based on observable market data
Note that disclosure of fair values is not required when the carrying
amount is a reasonable approximation of fair value, such as shortterm trade receivables and payables, or for instruments whose fair
value cannot be measured reliably (AASB 7. 29 (a))

Qualitative disclosures (AASB 7.33)

The qualitative disclosures describe:
- Risk exposures for each type of financial instrument
- Managements objectives, policies, and processes for managing
those risks - Changes from the prior period
Quantitative disclosures (AASB 7.34)
The quantitative disclosures provide information about the extent to
which the entity is exposed to risk, based on information provided
internally to the entitys key management personnel. Include:

- Summary quantitative data about exposure to each risk at

the reporting date

- Disclosure about credit risk, liquidity risk, and market risk

and how these

risks are managed

- The concentrations of risk
AASB 7. 36 42 and Appendix A and B:

 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 that are
settled by delivering cash or another financial asset
Market risk the risk that the fair value or future cash flows of
a financial instrument will fluctuate because of changes in market
prices. Market risk comprises three types of risk: currency risk,
interest rate risk and other price risk
Credit Risk (AASB 7.36-38 & Appendix A) Disclosures about credit
risk include:

- Maximum amount of exposure (before deducting the value

of collateral), description of collateral, information about credit
quality of financial assets that are neither past due nor
impaired, and information about credit quality of financial
assets whose terms have been renegotiated

- For financial assets that are past due or impaired, analytical

disclosures are required

- Information about collateral or other credit enhancements

obtained or called

Liquidity Risk (AASB 7.39 & Appendix A)

Disclosures about liquidity risk include:
- A maturity analysis of financial liabilities
- Description of the approach to risk management
Market Risk (AASB 7.40 & Appendix A) Disclosures about market risk
include:
- A sensitivity analysis of each type of market risk to which
the entity is exposed
- Additional information if the sensitivity analysis is not
representative of the entitys risk exposure (for example
because exposures during the year were different to
exposures at reporting date)