Chapter 13: Financial Instruments • Definition (according to IAS 32): financial

Chapter 13: Financial Instruments
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Definition (according to IAS 32):
A Financial Instrument is any contract that gives rise to a financial
asset of one entity and a financial liability or equity instrument of
another entity
– Financial asset:
cash, an equity instrument of another company, a contractual right…
– Financial liability:
a contractual obligation….
– Equity instrument:
any contract that evidences a residual interest in the assets of an entity
after deducting al of its liabilities
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This includes
– Accounts payable, accounts receivable, shares, loans, bonds,
derivatives
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Investment in Financial Assets
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Debt Securities
– bonds and notes
– funds (assets or services) are loaned to the investee
– investee has obligation to return asset and pay interest
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Equity Securities
– shares, e.g. ordinary shares
– investor gives assets in exchange for ownership rights
investor
funds
investee
securities
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Purposes of Financial Investments
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Cash Management
– holding of marketable assets to ease future transactions
• M&A and equipment
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Strategy
– long term equity investments
• to get access to knowledge, prevent an investee‘s takeover by a
competitor
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Risk protection
– assets counterbalancing risk exposure present in obligations
• exchange rate risk, interest rate risk
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Funding of liabilities
– assurance of meeting future liabilities
• e.g. pension liabilities
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IAS 39 Categorization
Financial assets
At fair value
through profit or
loss
Loans and
receivables
Held-to-maturity
Available-forsale
Other financial
liabilities
Designated at fair
value
Held for trading
Financial liabilities
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Valuation of financial instruments I
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Fair Value Through profit or loss
– Held for Trading: securities bought and held primarily for sale in the
near term (less than 3 month) to generate income on short-term price
differences
– Securities designated at fair value (“Fair Value Option”)
• reported at fair value
• change in value reported in net income
•
Loans and Receivables
– Non derivative financial assets with contractual cash flows, not traded in
an active market
– Reported at amortized costs
• Effective interest method is to be applied if long term
• for short term receivables: see chapter 10
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Valuation of financial instruments II
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Held-to-Maturity financial assets
– Debt Securities that the investor has the intent and the ability to hold to
maturity
– reported at amortized cost (e.g. bonds)
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Available-for-Sale financial assets
– securities that may be sold in the future
– reported at fair value
– changes in value reported in the shareholders’ equity section of the
balance sheet
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Other financial Liabilities
– Valued at amortized cost
– If opted accordingly at fair value through profit and loss
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Resulting approaches to Valuation
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Fair Value
Amortized cost
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Through profit and loss
Changes in value reported in equity
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What is most appropriate?
What are the reasons behind different accounting treatments?
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Example 1
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Investment in shares of another firm
Fair value through profit and loss
– Valued at market price at the end of the year, price change affects profit
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Available for Sale
– Valued at market price at the end of the year
– Income statement remains unaffected
10.000 shares are purchased at the beginning of the year at a price of € 10. At the
end of the year the stock price is € 7 per share.
Initial recognition:
dr investment in equity instrument
cr cash
End of the year adjustment:
either:
dr loss from equity investment
30.000
cr investment in equity instruments
or:
dr fair value change in equity
30.000
cr investment in equity instruments
100.000
100.000
30.000
30.000
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Example 2
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company starts with zero investments and buys shares for 20. Shares
go up to a price of 35
– case 1: nothing is done
– case 2: the shares are sold and immediately repurchased
Case 1 - Balance sheet effects after purchase
Case 2 - Balance sheet effects after purchase, sale and re-purchase
Investments
Investments
0
+ 20
20
Cash
300
- 20
280
0
+ 20
- 20
+ 35
Profit
15
35
Cash
300
- 20
+ 35
- 35
280
To ensure relevance of reported numbers, current market values should
be the basis for reporting (either through net income or other
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comprehensive income).
Example 3
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Crystal Company holds bonds from Ryan Corporation, Cleese Corporation,
and Kline Corporation:
Crystal Company
Trading debt security portfolio
December 31, 2003
Investments
Amortized
Cost
Ryan Corporation, 8% bonds
Cleese Corporation, 10% bonds
Kline Corporation, 7% bonds
Fair Value
Unrealized
Gain (Loss)
$ 101,305
368,095
68,500
$ 106,100
373,065
62,705
$ 4,795
4,970
(5,795)
537,900
541,870
3,970
Previous securities fair value adjustment balance
Securities fair value adjustment - Debit
0
$ 3,970
to record unrealized holding gains to income:
December 31, 2003
Securities fair value adjustment (trading)
Unrealized holding gain or loss - income
3,970
10
3,970
10
Example 4
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Crystal Company purchased $ 90,000 of 8% bonds from Ryan
Corporation on January 1, 2002, paying $ 78,784. Term to maturity
is 10 years; interest is payable each July 1 and January 1.
Crystal Company plans to hold the bonds for 10 years.
January 1, 2002
Held-to-maturity securities
Cash
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•
78,784
78,784
recorded at amortized cost
fair value, i.e. selling price, not relevant if securities are held to
maturity
– accounting treatment reduces volatility of reported earnings/capital
interest revenue = BCV * effective interest rate / 2
effective interest method
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Semiannual interest cash interest revenue to discount
periods
received
be recorded
amortization
Note:
The effective
interest rate
is 10%!
unamortized
discount
bond carrying
value
78.784
79.123
79.479
79.853
80.246
80.658
81.091
81.546
82.023
82.524
83.050
83.603
84.183
84.792
85.432
86.103
86.809
87.549
88.327
89.143
90.000
purchase date
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2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
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3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.939
3.956
3.974
3.993
4.012
4.033
4.055
4.077
4.101
4.126
4.153
4.180
4.209
4.240
4.272
4.305
4.340
4.377
4.416
339
356
374
393
412
433
455
477
501
526
553
580
609
640
672
705
740
777
816
11.216
10.877
10.521
10.147
9.754
9.342
8.909
8.454
7.977
7.476
6.950
6.397
5.817
5.208
4.568
3.897
3.191
2.451
1.673
857
20
3.600
4.457
857
0
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interest revenue is increasing because the carrying amount of the
bond is increasing
Journal entry to record first semiannual interest payment on July 1,
2002:
Cash
Held-to-Maturity Securities
Interest Revenue
3.600
339
3.939
... and the accrued interest at year-end 2002:
Interest Receivable
Held-to-Maturity Securities
Interest Revenue
3.600
356
3.956
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Balance sheet and Income Statement presentation
of the bond holding for the year ending December 31, 2002:
Balance Sheet
Current Assets
Interest Receivable
$ 3,600
Long-term Investments
Held-to-maturity investments, at amortized cost
$ 79,479
Income Statement
Other revenues and gains
Interest revenue
$ 7,895
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If the bond is sold close enough to maturity it may be considered
held to maturity because effects of interest rate changes on the fair
value are marginal.
– Example cont.: the bond is sold on November 1, 2011, at $ 89,820.
Selling price of bond (including accrued interest)
Less: book value of bond on November 1, 2011
Amortized cost, July 1, 2011
Add: Discount amortized
$ 89,820
$ 89,143
571
89,714
Gain on sale of bond
Journal entry to
record sale of bond:
$ 106
November 1, 2011
Cash
Held-to-maturity securities
Gain on sale of securities
89,820
89,714
106
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Example 5
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Assume now that Crystal Company holds the bond as available for
sale
in 2003 interest rates fall so that bond prices rise and in our example
the bond price at year end 2003 is $ 104,100.
– This means that Crystal Company records an unrealized holding gain of $
2,795 (= $ 104,100 - $ 101,305):
December 31, 2003
Securities fair value adjustment (available-for-sale)
Unrealized holding gain or loss - equity
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2,795
2,795
valuation account: securities fair value adjustment (available-for-sale)
– debits adjust value of available-for-sale securities upward
– credits downward
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Example 6:
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Investment in a portfolio of securities
Assuming the same numbers from the previous example and adding a bond
from Kline Corporation we have the following portfolio for Crystal Company
on December 31, 2003:
Crystal Company
Available-for-sale debt security portfolio
December 31, 2003
Investments
Amortized
Cost
Fair Value
Unrealized
Gain (Loss)
Ryan Corporation, 8% bonds
101,305
104,100
2,795
Kline Corporation, 7% bonds
68,500
62,705
(5,795)
169,805
166,805
(3,000)
Previous securities fair value adjustment balance
Securities fair value adjustment - Credit
0
$ (3,000)
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journal entry
December 31, 2003
Unrealized holding gain or loss - equity
Securities fair value adjustment (available-for-sale)
•
3,000
3,000
Modification of example: on July 1, 2004, the Kline bonds are sold for $
66,200. The fair value of the Ryan bonds is now $ 102,744.
(1) Determine gain
or loss on sale of
bonds.
Amortized cost
Less: selling price of bonds
$ 69,200
66,200
Loss on sale of bonds
$ 3,000
July 1, 2004
Cash
Loss on sale of securities
Available-for-sale securities
(2) Record the
loss on sale of
bonds.
66,200
3,000
69,200
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(3) Determine fair value adjustment
Crystal Company
Available-for-sale debt security portfolio
July 1, 2004
Investments
Ryan Corporation, 8% bonds
Amortized
Cost
100,744
Fair Value
Unrealized
Gain (Loss)
102,744
2,000
Previous securities fair value adjustment balance
(3,000)
Securities fair value adjustment - Debit
$ 5,000
and make the journal entry:
July 1, 2004
Securities fair value adjustment (available-for-sale)
Unrealized holding gain or loss - equity
5,000
5,000
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Disclosure in (Partial)
financial
statements
Income
Statement
Other revenues and gains
Interest revenue
$ xxx
Other expenses and losses
Loss on sale of bonds
§ 3,000
(Partial) Balance Sheet
Fixed assets
Available-for-sale securities, at fair value
Current assets
Interest receivable
Stockholders' equity
Accumulated other comprehensive income
$ 102,744
$ xxx
$ 2,000
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Accounting for derivatives
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Derivatives are financial instruments
– whose value changes in response to the change in a specified market
price, rate or index
– that require relatively low or no investment (leverage)
– that is settled at a future date
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Examples
– Options
– Futures or forward contracts
– interest rate swaps
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Generally, accounting for derivatives at “fair value through profit and
loss”
– exception: hedge accounting
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Hedge Accounting
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Cash flow hedges seek to protect against the change in future cash
flows due to risk
Fair value hedges seek to protect against changes in the fair value
of an asset or a liability
a hedge is effective if the changes in fair value or cash flow of the
hedged item and the hedging derivative offset each other
Hedge accounting matches the changes in value of the hedging
instrument with the ones of the hedged item
– Example: inventory of copper (usually valued at cost) and forward
selling contract both valued at fair value under hedge accounting
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Hedge accounting is controversial
Regulators subject it to restrictive conditions
– Managers often tend to avoid hedge accounting by violating one or
some of the conditions
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