CHAPTER 10

Financial Instruments

About This Chapter

This is possibly the most difficult topic not only for students but also for standard setters and companies. We are looking at a complex, fast-moving area usually involving significant sums of money. A company may make furniture, grow barley, supply transport, and offer health services, but they all need finance to operate.

They may raise finance internally by their own activities or externally by transactions in various financial markets. External finance is either short-term or long-term. Short-term financial markets, usually less than a year, are often called money markets. Long-term financial markets are capital markets, and include the equity market, the debt market, which includes borrowing from other firms, and the bank market.

Multinational companies that used to raise equity capital solely from sources within their own country now look to other countries for potential shareholders by listing their shares on a foreign exchange.

Companies engage in cross-border financing for a variety of reasons. Financial reasons include the fact that an entity might be able to obtain cheaper financing outside its own borders, lowering its overall cost of capital. In addition, it might find it convenient to obtain external financing in countries where it has significant operations.

Nonfinancial reasons to engage in cross-border financing include the objective to be a world-class enterprise maintaining financial relationships in many countries. An entity might wish to broaden its shareholder base to include citizens and other institutions from many countries in addition to its home base.

An entity could find it politically expedient to maintain financial relationships inside a particular country. The relationship could lead to additional business contacts both inside and outside of a foreign government or favorable recognition by the national government. In any case, cross-border financial activity is increasingly compatible with the cross-border movement of goods and services.

The problem of borrowing and lending substantial amounts in foreign countries can result in exposure to risks of various types, ranging from political instability to economic fluctuations. From a financial instrument perspective, there are two main risks:

• •The interest rate risk. The fair values or cash flows of interest-sensitive assets or liabilities will change if interest rates increase or decrease.
• •The exchange rate risk—the risk that changes in foreign currency exchange rates will negatively affect the profitability of an entity’s international operations.

Entities can use derivatives to offset the risks that these market forces will negatively affect fair values or cash flows. This use of derivatives to minimize these risks is known as hedging. The next section covers this important aspect of the use of financial instruments.

Deciding the appropriate accounting treatment for financial instruments has proved to be a major headache for the International Accounting Standards Board (IASB). A brief summary of standards issued illustrates the tortuous route that standard setters have followed to arrive at the present stage.

1986 IAS 25 Accounting for Investments—withdrawn in 2000 and ­replaced with IAS 40 Investment Property

1995 IAS 32 Financial Instruments: Presentation

1998 IAS 39 Financial Instruments: Recognition and Measurement

2003 IAS 39 Financial Instruments: Recognition and Measurement. Revised version reissued

2004 to 2009 During this period, 10 separate amendments were made to IAS 39

2005 IFRS 7 Financial Instruments: Disclosures

2009 IFRS 9 Financial Instruments. Replaces the classification and measurement of financial asset provisions in IAS 39

2010 IFRS 9 reissued with new requirements on accounting for ­financial liabilities.

2013 Two further amendments to IFRS 9

2014 IFRS 9 Financial Instruments issued and effective for annual periods beginning on or after January 1, 2018, with early adoption possible.

IFRS 9 Financial Instruments issued on July 24, 2014, is the IASB’s replacement of IAS 39 Financial Instruments: Recognition and Measurement. The standard includes requirements for recognition and measurement, impairment, derecognition, and general hedge accounting. The IASB completed its project to replace IAS 39 in phases, adding to the standard as it completed each phase.

The financial crisis of 2007–8 raised many concerns about the complexity of the standards and their application when accounting for financial instruments. Some argued that the standards contributed to the financial crisis as they forced some entities to record substantial losses that were not representative of what was actually happening. Some argued that it allowed companies to enter into dubious arrangements that were not correctly reported and misled investors.

The US Financial Accounting Standards Board (FASB) and the IASB worked toward the development of accounting standards for financial instruments. They were unsuccessful in developing a common standard, and it is argued in an article tracing the period 2009 to 2016 that it is now preferable for the two parties to continue with their own standards even if they are not converged (Hashim, Li, and O’Hanlon 2016). In this chapter, we discuss the requirements of the international standards.

IAS 32 Financial Instruments: Presentation

IAS 32 establishes principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. The focus for the classification is that of the issuer of the financial instruments. The standard links with IFRS 9, which deals with the recognition of financial assets and financial liabilities, and with IFRS 7, which deals with the disclosure of financial instruments.

The standard uses the term “entity” to include individuals, partnerships, incorporated bodies, trusts, and government agencies. It contains a long list of circumstances where the regulations do not apply. This is usually because other standards regulate certain entities and types of financial instruments.

The main thrust of IAS 32 is ensuring that, on initial recognition, the entity correctly classifies a financial instrument as a financial liability, a financial asset, or an equity instrument. Classification of financial assets usually presents no problems.

The major difficulty addressed by the standard is determining whether the instrument is an equity instrument or a financial liability. To be classified as an equity instrument, there are two conditions:

1. 1.The instrument must not include an obligation to deliver cash or another financial asset to another entity or to make a potentially unfavorable exchange of financial assets or liabilities with another entity.
2. 2.If the instrument can be settled by the issuer’s own equity, it must either be a nonderivative that does not require the issuer to deliver a variable number of its own equity instruments or a derivative that can be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.

There are two types of instruments that cause particular problems: puttable instruments and compound instruments.

Puttable Instruments

Puttable instruments come in two different forms that either:

1. 1.Give the holders the right to put the financial instrument back to the issuer for cash or another financial asset or
2. 2.Automatically put back the instrument to the issuer on the occurrence of an uncertain future event or the death or retirement of the holder of the puttable instrument.

Puttable instruments can be a financial liability or an equity instrument. To meet the second classification, the instrument must contain certain features. We summarize these as follows:

1. A)If an entity is liquidated, the holder of the puttable instrument is entitled to a pro rata share of the entity’s net assets.
2. B)It must be in the class of instruments that is subordinate to all other classes of instruments. This subordinate class of instruments must have identical features.
3. C)The only condition the contract must have is the obligation for the purchaser to purchase or redeem the asset for cash or another financial asset.
4. D)The total cash flows from the instrument are based on the profit or loss and changes in the recognized net assets or in the fair value of recognized and unrecognized net assets.

Compound Financial Instruments

An entity may issue a compound financial instrument that has both liability and equity components. In such cases, the entity must classify the components separately. Convertible bonds are one example of compound financial instruments. These usually require the issuer to deliver cash or another financial asset (a liability) but also grant the holder the right to convert the bond into a fixed number of ordinary shares (the equity).

To be classified as compound financial instruments, the main requirements are that:

• •they are nonderivative instruments that possess both equity and liability characteristics.
• •the equity and liability components must be separated on initial recognition. This process is sometimes referred to as “split accounting.” This involves first calculating the fair value of the liability component. The equity component is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.
• •the split and the amount of the liability and equity components are determined on initial recognition and not altered subsequently.

Many convertible bonds are classified as compound instruments. The procedure for split accounting is as follows:

1. A)The first stage is to calculate the carrying amount of the liability component. The method involves calculating the net present value of the discounted cash flows of interest and principal without including the possibility of exercise of the conversion option.
2. B)The carrying amount of the equity instrument represented by the conversion option is then determined by deducting the fair value of the financial liability calculated in (a) from the fair value of the compound financial instrument as a whole.

For the foregoing method to be applied, the bond must satisfy a “fixed for fixed” test. For example, with a convertible denominated in a foreign currency the conversion component may fail the fixed for fixed test. This is because the fixed amount of foreign currency does not represent a fixed amount of cash. The solution is to scrutinize the terms of each financial instrument to determine whether separate equity and liability components exist.

Schmidt (2013) examined the work of the FASB and the IASB in developing this standard and argued that the two parties used a dichotomous classification approach. This divides claims simply into liabilities and equity, but there is an ever-growing variety of hybrid financial instruments. He argues that this does not provide useful information, and a reconsideration of the traditional dichotomous classification might be a way forward.

Offsetting

The standard, under certain conditions, permits the offsetting of ­financial assets and liabilities. This is a process wherein the holder of ­financial assets and financial liabilities can set the amount of one against the other and only show the net amount on the statement of financial position.

An entity can make this type of transaction only where it has a current legal enforceable right to set off recognized amounts and intends either to settle on a net basis or to realize the asset and liability at the same time.

IAS 39 Financial Instruments: Recognition and Measurement

This main focus of IAS 39 is a transaction known as hedge accounting. An entity may have purchased a financial asset, and its value on the balance sheet is established by marking to market. The entity may be worried about adverse price movements, in other words, the value of the asset drops. This problem can be avoided by acquiring an offsetting position in a related security. If the value of the asset declines, this is balanced by an increase in the value of the hedge.

Although the financial actions are reasonably clear, the difficulty is the accounting treatment. The current regulation is that the ownership of the security and the opposing hedge are accounted for as one item. Examples of the types of financial instruments that are in the scope of IAS 39 are:

• •cash
• •demand and time deposits
• •commercial paper
• •accounts, notes, and loans receivable and payable
• •debt and equity securities. These are financial instruments from the perspectives of both the holder and the issuer. This category includes investments in subsidiaries, associates, and joint ventures.
• •asset-backed securities such as collateralized mortgage obligations, repurchase agreements, and securitized packages of receivables
• •derivatives, including options, rights, warrants, futures contracts, forward contracts, and swaps

IAS 39 does not include accounting for equity instruments and entity issues. It does set the requirements for accounting for financial liabilities. IAS 32 determines the classification of financial instruments as either equity or liability.

The purpose of IAS 39 is to ensure that all entities apply the regulations to all financial instruments within the scope of IFRS 9 Financial Instruments if, and to the extent that:

1. 1.IFRS 9 permits the application of the hedge accounting requirements of IAS 39.
2. 2.The financial instrument is part of a hedging relationship that qualifies for hedge accounting in accordance with this standard.

The standard defines the various terms connected to the process of hedging. These are:

Firm commitment

A binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Forecast transaction

An uncommitted but anticipated future transaction.

The activities of hedging and using hedging instruments have many specific terms. The key points are explained in the following section.

Hedging Instrument

A designated derivative (applies to foreign exchange hedges only) or a designated nonderivative financial asset or nonderivative financial liability whose fair value or cash flows are expected to offset changes in the fair value of a designated hedged item.

Hedged Item

An asset, liability, firm commitment, highly probable forecast transaction, or net investment in a foreign operation that (a) exposes the entity to risk in changes of fair value or future cash flows and (b) is designated as being hedged.

Hedged Effectiveness

The degree to which changes in fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.

The preceding terms are not easy to understand immediately. The meaning of the terms becomes clear as we draw from the requirements of the standard to demonstrate their application.

Hedging Relationships

There are three types of hedging relationships:

1. 1.Fair value hedge
   This is a hedge relating to a recognized financial asset, liability, or firm commitment where there is the risk of changes in fair value.
2. 2.Cash flow hedge
   This is a hedge where there is the risk of variability in cash flow that is associated with a recognized asset or liability.
3. 3.The hedge of net investment in a foreign operation. IAS 21 defines a foreign operation as an entity that is a subsidiary, associate, joint arrangement, or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.

Derivatives as Hedging Instruments

There are five conditions under which an entity can determine a derivative is a hedging instrument. These conditions have some technical details, so we have extracted the following main requirements.

1. 1.When the hedging relationship commences, there must be a formal designation and document of the relationship. This includes the entity’s risk management and the objective and strategy for undertaking the hedge.
2. 2.The entity expects the hedge to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.
3. 3.For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss.
4. 4.The effectiveness of the hedge can be reliably measured.
5. 5.The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated.

Accounting for Fair Value Hedges

1. 1.Any gain or loss from remeasuring the hedging instrument at fair value is recognized in profit or loss.
2. 2.Any gain or loss on the hedged item attributable to the hedged risk adjusts the carrying amount of the hedged item and is recognized in profit or loss.
3. 3.Fair value hedge accounting is discontinued prospectively if:

• •The hedging instrument expires or is sold, terminated, or exercised.
• •The hedge no longer meets the five conditions described previously.
• •The entity revokes the designation.

1. 4.Where hedge accounting is discontinued, adjustments to the carrying amount of a hedged financial asset for which the effective interest rate is used are amortized to profit or loss.

Accounting for Cash Flow Hedges

1. 1.The part of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognized in the ­statement of other comprehensive income. (We explained the statement of comprehensive income in Chapter 3.) The ineffective part of the gain or loss on the hedging instrument is recognized in profit or loss.
2. 2.The hedge may result in the recognition of a financial asset or a financial liability. In this case, the associated gains or losses that were recognized in other comprehensive income are reclassified from equity to profit or loss as a reclassification adjustment.
3. 3.Where the hedge results in the recognition of a nonfinancial asset or a nonfinancial liability, the standard permits the entity to select from a choice of accounting policies.
4. 4.Cash flow hedge accounting is discontinued prospectively if:

• •The hedging instrument expires or is sold, terminated, or exercised
• •The hedge no longer meets the five conditions
• •The forecast transaction is no longer expected to occur
• •The entity revokes the designation

Accounting for Hedges of a Net Investment in a Foreign Operation

Hedges of a net investment in a foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment, are accounted for similarly to cash flow hedges.

The part of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognized in equity, and the ineffective part is recognized in profit or loss.

The gain or loss on the hedging instrument relating to the effective portion of the hedge that has been recognized in the statement of other comprehensive income is reclassified from equity to profit or loss as a reclassification adjustment on the disposal of the foreign operation.

IFRS 7 Financial Instruments: Disclosures

The use of financial instruments by companies has expanded, and there have been various developments. The challenge facing the IASB has been to meet users’ needs for information about risk exposure and how the entity manages it in a market where there have been significant changes. This turbulence has resulted in the IASB having to make several changes to standards. This makes it difficult for both the preparers and the users of financial statements.

In 2003, all disclosure requirements were transferred to IAS 32. This resulted in that standard being renamed Financial Instruments: Disclosure and Presentation. In 2005, the IASB issued IFRS 7 Financial Instruments: Disclosures to replace the disclosure requirements in IAS 32. This became effective from January 1, 2007.

The latest two amendments in the standard regulate the transfers of financial assets (applicable for financial years beginning on or after July 1, 2011) and offsetting financial assets and financial liabilities (applicable for financial years beginning on or after January 1, 2013). In addition, some disclosure requirements previously included in IFRS 7 were transferred to IFRS 13.

The objectives of IFRS 7 are to require disclosures regarding financial instruments that enable users to evaluate:

1. 1.Their significance for the entity’s financial position and performance.
2. 2.The nature and extent of risk to which the entity is exposed during and at the end of the reporting period and how the entity manages those risks.

The standard is wide in scope and includes a list of the financial instruments that are covered by it. The standard applies to all entities: those with only a few financial instruments and those with many. The amount of disclosure required depends on the range and number of financial instruments held.

IFRS 7 is divided into two distinct sections. The first section covers quantitative disclosures about the numbers in the balance sheet and the income statement. The second section deals with qualitative risk disclosures. These are the management’s objectives, policies, and processes for managing those risks.

The quantitative disclosures provide information about the extent to which the entity is exposed to risk, based on information provided internally to the entity’s key management personnel. The standard identifies the different types of risk to which the entity may be exposed. These are credit risk, liquidity risk and market risk.

An Australian survey (Birt, Rankin, and Chen 2013) of companies in the extractive industries study concluded that derivative use is positively associated with financial risk and firm size. Using a disclosure index based on the additional requirements in IFRS 7, they concluded that large firms with higher leverage use derivatives and audited by a Big 4 auditor provide more extensive disclosure than other firms.

IFRS 9 Financial Instruments

In 2014, IFRS 9 Financial Instruments was issued as a replacement for IAS 39 Financial Instruments: Recognition and Measurement. The version of IFRS 9 issued in 2014 supersedes all previous versions and is mandatorily effective for periods beginning on or after January 1, 2018, with early adoption permitted.

IFRS 9 is a lengthy standard that addresses the weaknesses of accounting for financial instruments revealed by the 2007–8 financial crisis. It also incorporates in one standard the three major activities of accounting for financial instruments: classification and measurement, impairment, and hedge accounting. The standard includes requirements for recognition and measurement, impairment, derecognition, and general hedge accounting.

IFRS 9 sets out the requirements for reporting financial assets and financial liabilities with the aim of ensuring that users are better able to determine the amounts, timing, and uncertainty of an entity’s future cash flows. The main requirements are:

Accounting for Financial Assets

Entities must estimate and account for expected credit losses for all relevant financial assets from the date they first lend money or invest in a financial instrument. This provides the users of financial statements with information on an entity’s exposure to credit risk.

Accounting for Financial Liabilities

If an entity chooses to measure liabilities at fair value, it must include them on the statement of financial position at full fair value.

Hedge Accounting

The standard contains a new hedge accounting model that brings risk management and accounting closer together. This provides the users of financial statements with a link between accounting transactions and the risk management policies of an entity. It also reveals the impact of hedge accounting on the financial statements.

IFRS 9 is structured into four main accounting issues, namely, recognition and derecognition, classification, measurement, and hedge accounting. The standard also explains accounting for financial assets, financial liabilities and equity, and hedge accounting. These are complex issues, but we have summarized them in what follows.

Financial Assets

Financial assets, for accounting purposes, are similar to other assets and appear as such on the balance sheet of the acquirer. Financial assets include debt instruments where the entity expects to be repaid the loan it has made and equity instruments (shares) where the entity has ownership interest in the residual net assets of another entity. This division is important as we look at classification and measurement of financial assets.

The main requirements for the recognition and derecognition of financial assets are straightforward. When an entity becomes party to the contractual provisions of the instrument, it recognizes the financial asset in its statement of financial position. An entity derecognizes a financial asset when either the cash flows from the financial asset cease or it transfers the financial asset.

It is possible that an entity decides to change its business model for financial assets. Instead of holding the asset for the contractual cash flows until maturity, it could decide to sell it before maturity or vice versa. If the business model objective for its financial assets changes, its previous recognition model may no longer apply, and the entity may change it.

The “value” of financial assets can become impaired. The standard applies the same impairment model to all types of financial assets covered by the standard. There are exceptions for purchased or originated credit-impaired financial assets.

Financial Liabilities and Equity

Financial liabilities can include debt instruments where the issuing entity has to pay regular interest and repay the principal. Equity instruments entail an issue of shares. In both instances, the financial instruments appear on the balance sheet, and the standard sets out the requirements.

Financial liabilities are divided into either amortized cost or fair value through profit or loss (FVTPL). If financial liabilities are classified as amortized cost, the initial measurement is at fair value less the issue costs. Subsequent measurement is at amortized cost.

Hedge Accounting

A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:

1. 1.the hedging relationship consists only of eligible hedging instruments and eligible hedged items.
2. 2.at the inception of the hedging relationship, there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge.
3. 3.the hedging relationship meets all of the hedge effectiveness requirements.
   A hedged item must be reliably measurable and can be

• •a recognized asset or liability,
• •an unrecognized firm commitment,
• •a highly probable forecast transaction,
• •a net investment in a foreign operation.

There are three types of hedging relationships:

1. 1.Fair value hedge
   A hedge that is exposed to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss (or other comprehensive income [OCI] in the case of an equity instrument designated as fair value through other comprehensive income [FVOCI]).
2. 2.Cash flow hedge
   The cash flow hedge reserve in equity is adjusted to the lower of the following (in absolute amounts):

• •the cumulative gain or loss on the hedging instrument from ­inception of the hedge; and
• •the cumulative change in fair value of the hedged item from ­inception of the hedge.

1. 3.Hedge of a net investment in a foreign operation
   This type of hedge includes a monetary item that is accounted for as part of the net investment. The accounting is similar to cash flow hedges:

A hedging relationship must be effective to qualify for hedge accounting. To verify this, the relationship must satisfy the following effectiveness criteria at the beginning of each hedged period:

• •there is an economic relationship between the hedged item and the hedging instrument;
• •the effect of credit risk does not dominate the value changes that result from that economic relationship; and
• •the hedge ratio of the hedging relationship is the same as that actually used in the economic hedge.

As the standard addresses four main accounting issues, it is not surprising that it has a significant impact on the information gathering and classification in a company and the consideration of risk. This will move companies from being concerned only with traditional risk compliance to strategic risk management (Ozdemir 2017).

Conclusions

The regulatory position has seen several standards dealing with various aspects of financial instruments. The position is not easy for preparers, users, and auditors. The mix of standards regulating differing aspects of financial instruments with various effective dates and a significant number of amendments and revisions over the years caused problems.

The IASB, with the issue of IFRS 9, addressed the criticisms that had been made on accounting for financial instruments. However, the complete solution may rest not in the power of the standard setters but in the strength of the legal requirements established by various governments that have their own agendas.

Currently, the standard setters are focused on IFRS 9, which became effective for periods beginning on or after January 1, 2018. Only time will reveal whether the standards address all of the uncertainties that existed. The position may also be helped by the issue of a new standard IFRS 17 Insurance Contracts. It is intended that the effective date for IFRS 17 will be 2022, allowing insurers to apply the financial instruments standard, IFRS 9. This should result in both IFRS 9 and IFRS 17 being effective at the same time.