Financial Instruments

What is a financial instrument?

► A financial instrument is any contract that gives rise to

both a financial asset in one entity and a financial liability
or equity instrument in another entity

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What is a financial asset?

► A financial asset can be cash, an equity instrument of

another entity, or a contractual right to receive cash or
another financial asset from another entity or to
exchange financial assets or financial liabilities with
another entity under conditions that are potentially
favourable to the entity.

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What is a financial liability?

► financial liability is any contractual obligation to deliver

cash or another financial asset with another entity, or to
exchange financial assets or financial liabilities with
another entity under conditions that are potentially
unfavourable to the entity.

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What is an equity instrument?

► An equity instrument is any contract that evidences a

residual interest in the assets of an entity after deducting
all of its liabilities.

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What is fair value?

► Fair value is the amount for which an asset could be

exchanged, or a liability settled, between
knowledgeable, willing parties in an “arm’s length
transaction.”

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Types of instruments

► What types of financial instruments do you know?

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Types of instruments (continued)

► Cash
► Bank accounts
► Loans
► Leases
► Deposits
► Financial guarantees
► Promissory notes

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Types of instruments (continued)

► Bonds
► Shares
► Units of unit investment funds
► ADRs/GDRs
► Credit linked notes (CLNs)
► Collateralised debt obligations (CDOs)
► Convertible bonds

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Types of instruments (continued)

► Forwards
► Futures
► Options
► Currency swaps
► Interest rate swaps
► FRAs
► Credit default swaps (CDS)

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Overview of IAS 32 and IAS 39
IAS 32

► IAS 32 “Financial Instruments: Presentation”

► Provides guidance for:
► Classification
► Presentation;

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IAS 39

► IAS 39 “Financial Instruments: Recognition and

Measurement”
► Provides guidance for:
► Recognition and derecognition
► Classification
► Measurement
► Hedge accounting

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Classification of Financial Assets

Category Main use

Fair value All derivatives (outside designated hedges)
through profit or Other items intended to be actively traded
loss Any item designated as such that meets criteria

Held-to-maturity Debt assets acquired by the entity to be held to maturity

Loans and Conventional loan assets that are unquoted (originated or

receivables acquired), trade receivables

Available-for-sale All assets not in the above categories

It is a residual category - does not mean that the entity stands
ready to sell these

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Classification of Financial Liabilities

Category Main use

Fair value All derivatives (outside designated hedges)
through profit or Other items intended to be actively traded
loss Any item designated as such that meets criteria

Other liabilities All liabilities not in the above category

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Financial Instruments at FV through P&L

► A financial asset (or financial liability) at fair value through profit or

loss is one that is either:
► Held for trading; or
► Designated at initial recognition
► A financial instrument must be classified as held for trading if it is:
► Acquired or incurred principally for the purpose of selling or repurchasing
it in the near term;
► Part of a portfolio of identified financial instruments that are managed
together and for which there is evidence of a recent actual pattern of
short-term profit-taking; or
► A derivative (except for designated and effective hedging instruments)

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Debt vs. Equity
Debt vs. Equity

► IAS 32 provides principles for the distinction between

liabilities and equity classification
► Substance over legal form (in theory)
► Liability = Issuer can be required or has the option to
deliver cash
► Equity = Represents a residual interest in the net assets
of the Issuer

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Debt vs. Equity (continued)

► Financial instruments (compound instruments) that

contain both a liability and equity component must be split
and accounted for separately.
► The liability component is determined by fair value of
expected cash flows (excluding the equity component)
and the residual is allocated to the equity component.

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Measurement
Fair Value at Initial Recognition

► The best evidence of the fair value at initial recognition is

the transaction price (i.e., the fair value of the
consideration given or received) unless:
► The fair value of that instrument is evidenced by comparison with
other observable current market transactions in the same
instrument (ie, without modification or repackaging); or
► Based on a valuation technique whose inputs include only data
from observable markets

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Fair Value – Active Market

► Published price quotation in an active market is the best

evidence of fair value and must be used to measure fair
value where possible
► Fair value of portfolio of financial instruments is the product of
number of units of the instrument and its quoted market price
► No block discounts allowed due to the size of the position

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Fair Value – Inactive Markets

► When current bid or offer prices are unavailable, price of

the most recent transaction provides evidence of fair
value
► If conditions have changed since the transaction the fair value
reflects the change by reference to current prices or rates for
similar financial instruments
► If the entity can demonstrate that the last transaction is not fair
value the price is adjusted

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Fair Value – Inactive Markets (continued)

► If market is not active an entity establishes fair value using a valuation

technique. For example:
► Most recent arm’s length transaction between knowledgeable, willing
parties;
► Reference to fair value of a similar instrument;
► Discounted cash flow; or
► Option pricing models.
► The valuation technique used must:
► Incorporate all factors that market participants would consider in setting a
price; and
► Be consistent with accepted economic methodologies for pricing financial
instruments.

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Effective Interest Method

► The rate that exactly discounts estimated future cash

flows through the expected life of the financial instrument
(or when appropriate, a shorter period) to the net carrying
amount of the instrument
► A method of allocating the interest income or expense over the
relevant period; and
► Of calculating the amortised cost

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Illustration of Effective Yield Method

► Bond with issue value of 1,000,000 pays 5% for 2 years,

then 7% thereafter, annually on anniversary of issue.
► Option to prepay or extend after 4 years.
► The holder does not anticipate the cash flows extending
beyond year 4.

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Illustration of Effective Yield Method
(continued)

Yield 5.94235%

Year b/f Cash Interest c/f

1 1,000,000 (50,000) 59,424 1,009,424

2 1,009,424 (50,000) 59,983 1,019,407

3 1,019,407 (70,000) 60,577 1,009,984

4 1,009,984 (1,070,000) 60,017 0

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Impairment
General Impairment Rules

► A financial asset is impaired when:

► Carrying amount > Estimated recoverable amount
► Must assess for evidence of impairment at each balance sheet
date
► If any evidence of impairment, must estimate the
recoverable amount and recognise any impairment loss
► Incurred loss model rather than an expected loss model

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Impairment – Available-for-sale Assets

► Guidelines for objective evidence of impairment for equity

instruments
► A significant or prolonged decline in fair value below the cost now
represents objective evidence of impairment
► No concept of temporary
► Impairment on equity instruments cannot be reversed
► Impairment on debt instruments can be reversed, under
certain circumstances

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Impairment – Amortised Cost Assets

► Guidelines for objective evidence of impairment

► Separate assessment for those individually significant
► Collective impairment assessment does not equal general
provisions and/or Basel II

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Objective Evidence?

► At each balance sheet date an entity must assess if there is objective

evidence of impairment.
► Objective evidence includes:
► Financial difficulty of issuer;
► Default or delinquency, or concessions by lender;
► High probability of bankruptcy or financial reorganisation;
► Disappearance of active market in investment due to financial problems;
► Historical pattern of collections of a group of financial assets that implies
that holder will not collect all amounts due.

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Collective Assessment

► Collective assessment for amortised cost financial

assets includes:
1. Groups of similar financial assets that are not individually
significant; and
2. Individually significant financial assets reviewed with no required
impairment
3. Recognition of losses known to exist in the portfolio but not yet
evident

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IFRS 7 Financial Instruments:
Disclosures
IFRS 7 Objective

► To provide information
► to enhance understanding of the significance of financial
instruments to an entity’s
► financial position,
► performance, and
► cash flows
► to assist in assessing the amounts, timing, and certainty of future
cash flows associated with those instruments.
► Aims to provide the information in the context of risks

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IFRS 7 Risks arising from Financial Instruments

Typical risks arising from financial instruments

Credit risk Liquidity risk Market risk

Interest rate risk Currency risk Other price risks

Share price Commodities price Recovery risk Prepayment risk

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 IFRS 7 Quantitative Disclosures

► For each type of risk arising from financial instruments to

which an entity is exposed at the reporting date, it shall
disclose summarised quantitative data
Ø The disclosures have to be based on the information provided
internally to key management personnel, for example, the entity’s
board of directors or chief executive officer.

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Conclusion

► Questions?

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