A86045 Accoun,ng and Financial Repor,ng (2015/2016)

Transcription

1 A86045 Accoun,ng and Financial (2015/2016) Session 7 Non-current Financial Assets and Liabili,es Paul G. Smith B.A., F.C.A.

2 SESSION 7 OVERVIEW 2

3 Course Objec,ves At the end of this course students will be able to: Read and perform a high level interpreta2on of the financial statements of companies applying interna9onal accoun9ng standards Iden2fy and evaluate the impact on a companies accounts of alterna9ve accoun9ng methods Carry out a high level assessment of the the economic- financial posi9on of a company repor9ng under IAS/IFRS. 3

4 Course Overview 1. Financial repor,ng under IFRS 15. Inventories 2. Financial analysis and ra,os 16. Review 3. Financial analysis and ra,os - cont d 17. Accounts receivable 4. Review 18. Group accounts 5. Revenues 19. Taxa,on (direct and indirect) 6. Costs and expenses 20. Non-financial liabili,es 7. Non-current financial assets/liabili,es 21. Review 8. Non-current assets - Tangible assets 22. Review 9. Financial leases 23. Cash Flow Statement 10. Review 24. Review 11. Non-current assets - Intangible assets 25. Review 12. Impairment of assets 26. Business combina,ons 13 Review 27. Final test 14. Mid term test 4

5 Session 7 Overview Mins Session overview and objec,ves 5 Review of pre-work and session 6 recap 5 Financial Instruments - Standards and defini,ons 20 Fair Value and Amor,zed Cost 20 Risk Management 30 Overview of session 8, required reading and assignment for next session Summary and valida,on

6 Objec,ves of Session At the end of this session session students will be able to: Define what a Financial Instrument is and ar,culate the rules for recognizing, classifying and measuring non-current financial assets and liabili,es. Understand the market risks to which a company is exposed and the financial instruments used by companies to mi,gate these risks. 6

7 SESSION 6 RECAP AND PRE-WORK SESSION 7 7

8 Session 6 Summary Classifica,on of costs/expenses by nature or by des,na,on Cost of goods sold Other costs/expenses accruals/deferrals Employee expenses Payroll Pensions Stock op,ons 8

9 Session 7 Pre-work Reading Melville Interna,onal Financial A Prac,cal Guide : Chapter 11 Financial Instruments IASB Technical Summaries IAS 32 Financial Instruments: Presenta,on IAS 39 Financial Instruments: Recogni,on and Measurement IFRS 7 Financial Instruments: Disclosures IFRS 9 Financial Instruments Exercises Melville , Plus on-line mul,ple choice ques,ons for chapter 14. EX 6. Costs and Expenses Research Iden,fy the nature of the Financial Instruments in your chosen company and be prepared to discuss how they are classified and accounted for. 9

10 FINANCIAL INSTRUMENTS 10

11 Financial Instruments A business creates financial assets and liabili,es through: Buying and selling on credit Borrowing to finance itself Inves,ng in equity and other instruments Raising addi,onal cash from shareholders Risk management ac,vi,es Companies are exposed to the following risks: Credit risk (Counterparty can t meet its obliga,ons) Liquidity risk (Company can t meets its own obliga,ons) Market risk (Fair value or future cash flows of a financial instrument will fluctuate due to changes in market prices) Price Interest rate Exchange rate 11

12 Financial Instruments Non-deriva?ves Current Non-current Equity Financial assets Financial liabili,es Compound Financial Instruments Deriva?ves Interest rate Foreign currency Commodity Equity investments Cash, Short-Term Investments, Accounts Receivable Bank overdraes, Shortterm Loans, Accounts Payable Swaps, foreign currency swaps Investments, Loans and Receivables Long-term Loans, Borrowings Debt Op,ons, forward contracts, collars, swaps Forward contracts, futures, op,ons Equity based deriva,ves Equity Risk management tools 12

13 Financial Instruments Topic addressed Issue date Effec?ve date IAS 32 Presenta,on* 12/2003 1/2005 IAS 39 Impairment, hedge accoun,ng IFRS 7 Disclosures 8/2005 1/2007 IFRS 9 (2009, 2010,2013) IFRS 9 Classifica,on and measurement Recogni,on, de-recogni,on, classifica,on, measurement, hedge accoun,ng * Disclosure requirements transferred to IFRS 7. Now deals mainly with the classifica,on of debt/equity instruments from issuer perspec,ve 12/2003 1/2005 EU Macro hedging carve out 10/2010 1/2015 Not endorsed by EU 7/2014 1/2018 Not endorsed by EU The IASB s goal is that IFRS 9 will ul,mately replace IAS 39 in three phases: 1. Classifica,on and measurement of financial assets and liabili,es 2. Impairment methodology 3. Hedge accoun,ng 13

14 Financial instruments Defini?on: any contract that gives rise to a financial asset of one en2ty and a financial liability or equity instrument of another (IAS 32) Financial asset any asset that is: Cash An equity instrument of another en,ty A contractual right: To receive cash or another financial asset from another en,ty; or To exchange financial assets or financial liabili,es with another en,ty under condi,ons that are poten,ally favorable to the en,ty; or A contract that will or may be seiled in the en,,es own equity instruments and is: A non-deriva,ve for which the en,ty is or may be obliged to receive a variable number of the en,ty s own equity instruments; or A deriva,ve that will be seiled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the en,ty s own equity instruments. Financial liability any liability that is: A contractual obliga,on To deliver cash or another financial asset to another en,ty; or To exchange financial assets or financial liabili,es with another en,ty under condi,ons that are poten,ally unfavorable to the en,ty; or A contract that will or may be seiled in the en,,es own equity instruments and is: A non-deriva,ve for which the en,ty is or may be obliged to deliver a variable number of the en,ty s own equity instruments; or A deriva,ve that will or may be seiled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the en,ty s own equity instruments. Equity instrument is any contract that evidences a residual interest in the assets of an en,ty aeer deduc,ng all of its liabili,es 14

15 Financial instruments Recogni,on and measurement A financial asset or liability is only recognized in the balance sheet when, and only when, the en9ty becomes a party to the contractual provisions of the instrument. Prior to this there are no contractual rights or obliga9ons. Examples Accounts Receivable and Accounts payable Firm commitments to purchase or sell goods and services Forward contracts Op,on contracts Planned future contracts (forecast transac,ons) Recogni?on criteria met Yes legal right to receive or obliga,on to pay cash. No not un,l one of the par,es has performed under the agreement Yes It is a contract and recognized at the commitment date. It is recognized at the fair value of the right and obliga,on. Yes - Right to buy call or sell put. Bought by the purchaser or wriien by the party with the obliga,on. Can be in the money or out of the money No the en,ty is not party to a contract. But could be if a hedge and highly probable 15

16 Ini,al Recogni,on Both IAS 39 and IFRS 9 require that financial assets and liabili,es be measured ini,ally at their Fair Value. This is normally the amount of the considera,on given or received when the asset was acquired or the liability incurred. 16

17 Fair Value IFRS 13 Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transac9on between market par9cipants. Fair value hierarchy: Level 1 inputs: quoted prices in ac,ve markets for iden,cal assets or liabili,es Level 2 inputs: inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly or indirectly e.g. quoted prices for similar assets or liabili,es Level 3 inputs: are unobservable inputs for the asset or liability. These should reflect assump,ons that market par,cipants would use when pricing an asset or liability, including assump,ons about risk. 17

18 Subsequent measurement Classifica?on Instrument Balance Sheet FV Gains/Losses Interest/dividend income Impairment Fair Value Profit & Loss (FVP&L) Debt, Equity, deriva,ve* Equity not reliably measurable Fair value Profit or loss Profit or loss Profit or loss Cost Profit or loss: dividends Profit or loss Held To Maturity (HTM) Loans & Receivables (L&R) Available For Sale (AFS) Other Financial Liabili,es (OFL) Debt Amor,zed cost Profit or loss: Effec,ve interest rate Debt Amor,zed cost Profit or loss: Effec,ve interest rate Debt Fair value Other comprehensive income Equity Fair value Other comprehensive income Equity not reliably measurable * Not designated in effec,ve hedging rela,onships Cost Profit or loss: Effec,ve interest rate Profit or loss: dividends Profit or loss: dividends Debt Amor,zed cost Profit or loss: Effec,ve interest rate Profit or loss Profit or loss Profit or loss Profit or loss Profit or loss 18

19 Assets Classifica,on IAS 39 Financial assets at fair value through Profit and loss (FVPL) Held for trading Designated OIR* (FV Op,on) Available-for-sale financial assets (AFS) (those designated as such or not classified in any other category) Held-to-maturity investments (HTM) (those with fixed and determinable payments and fixed maturity and inten9on and ability to hold to maturity) Loans and receivables (L&R) (those with fixed and determinable payments that are not quoted in an ac9ve market and do not qualify as trading assets) For natural offsets and to avoid accoun,ng mismatch Liabili,es Financial liabili9es at fair value through Profit and loss (FVPL) Held for trading Designated OIR* (FV Op,on) Other financial liabili,es (OFL) (not explicitly defined but are those that are not held for trading or designated as such) * On Ini,al Recogni,on 19

20 Classifica,on - IFRS 9 Debt Instrument Deriva,ve Equity Instrument Business model test? Yes Characteris,cs of the financial asset test? Yes No No Yes No Held-for trading? No Fair value through OCI op,on? Fair Value Op,on (FVO) used? Yes Yes No Amor,zed cost Fair value through profit or loss Fair value through OCI 20

21 Subsequent measurement Assets Equity Instrument FVP&L FVOCI Debt Instrument FVP&L FVOCI Liabili?es Financial Liabili,es Trading Trading FVP&L Non-trading/AFS Non-trading (OFL) FVOCI Held to Maturity (HTM) Amor,sed Cost using EIR Amor,sed Cost using EIR Deriva?ves FV Hedge Cash Flow Hedge Net Investment P&L OCI OCI 21

22 FINANCIAL ASSETS 22

23 Financial assets Equity shares Quoted/Listed companies Privately held companies Debt Securi,es/Bonds/Obliga,ons/Debentures Loans and receivables Deriva,ves 23

24 Investments in Equity shares % Ownership Defini?on Accoun?ng > 50 % Subsidiary Only relevant in parent company only financial statements as this would be eliminated on consolida,on 20 50% Equity investee or Associated company < 20% Listed securi,es Unlisted securi,es Accounted for using the equity method i.e. one line Accoun,ng depends on the purpose for holding Trading Non-trading (AFS)* Cost and tested for impairment Will be covered in Session 22 Trading: Fair value through profit and loss (FVPL) Non trading: Fair value through (FVOCI) (Unless impaired i.e. significant and prolonged decline in value) * Available for Sale (AFS) 24

25 Investments in Debt Securi,es Inten?on Accoun?ng Requirements Trading Hold to maturity (HTM) Available for sale (AFS) Fair value through profit and loss account (FVPL) Amor,zed cost using the Effec,ve Interest Rate method Fair value through other comprehensive income (FVOCI) Inten,on and ability to hold to maturity 25

26 Ini,al measurement Fair value example Company A lends 1,000 to Company B for 5 years and classifies the resul,ng asset within loans and receivables. The loan carries no interest, and instead, A expects (or possibly contracts) to receive other future economic benefits, such as the right to receive goods and services at favorable prices or an implicit right to exert influence over the ac,vi,es of B. On ini,al recogni,on, the market rate of interest for a similar 5 year loan with payment of interest at maturity is 10% per year. The ini,al fair value of the loan is the present value of the future payment of 1,000, discounted using the market rate of interest for a similar loan of 10% for 5 years. This equates to 621. The difference of 379 is recorded as an expense. 26

27 Future Value/Present Value Market Interest rate 10% Future Value at 10% Interest Present Value at 0% Interest Comparison of the value today and the value in 5 years,me of a 5 year loan of CU 1,000 at 0% interest and at 10% interest P0 1, P , P , P , P , P ,611 1,000 Formulae 1,000 * (1.10) 5 1,000 (1.10) 5 27

28 Amor,zed cost and the Effec,ve interest rate method Amor,zed cost: of a financial instrument is defined as the amount at which it was measured at ini,al recogni,on minus principal repayments, plus or minus the cumula,ve amor,za,on using the effec9ve interest rate method of any difference between that ini,al amount and the maturity amount, and minus any write-down for impairment or uncollectability. Effec,ve interest rate method: is a method of calcula,ng the amor,zed cost of a financial instrument and of alloca,ng the interest income or expense over the relevant period. The effec9ve interest rate is the rate that exactly discounts es,mated future cash payments or receipts over the expected life of the instrument or, when appropriate, a shorter period, to the instrument s net carrying amount. 28

29 Debt instrument at amor,zed cost On 1 January 2013 a company buys 100,000 of 6% loan stock for 93,930. Interest is received on December 31 each year. The loan is redeemable at par on 31 December Step 1 Calculate the Effec?ve Interest Rate Step 2 Calculate the Amor?zed Cost Present Cash Flows Value Opening Interest Amor?sed Proof Balance 7.50% Received Cost Jan ,930 Dec ,000 / , ,930 7,045-6,000 94,975 Dec ,000 /(1.075) 2 5, ,975 7,123-6,000 96,098 Dec ,000 /(1.075) 3 4, ,098 7,207-6,000 97,305 Dec ,000 /(1.075 )4 4, ,305 7,298-6,000 98,603 Dec ,000 /(1.075) 5 73, ,603 7, , ,931 IRR 7.50% Source: Alan Melville: Interna,onal Financial N.B. You can use Excel to calculate the IRR 29

30 Debt instrument Available for sale Available for sale asset A company acquires a zero coupon bond at the end of 2013 for 760, its fair value, which matures at the beginning of 2017 at 1,000. It is classified as an available-for-sale asset and, accordingly, associated fair value gains and losses are recognized in other comprehensive income. Its fair value at the end of 2014, 2015 and 2016 is 850, 950, and 1,000 respecyvely and it can be determined that the effecyve interest rate is 9.6%. The financial statements would include the accounyng entries set out in the table. (amoryzed cost is memorandum informayon used to determine interest). IRR Amortized cost at start of year Interest income Profit and Loss Gains and losses - other comprehensive income Cash flow Fair Value B/Sheet (=760 x 9.6%) 17 (= ( )) (= ) 80 (=833 x 9.6%) 20 (= ( )) (= ) 87 (=913 x 9.6%) -37 (= ( )) (= ) % 30

31 SOURCES OF FINANCE 31

32 Financing Contractual obliga,on to deliver cash Debt Debt Instruments/ Borrowings Compound Financial Instruments Equity Equity No contractual obliga,on to deliver cash Bank Loans Corporate Bonds Obliga,ons Conver,ble bonds Redeemable Preference Shares Equity shares Preference shares Treasury shares Finance Leases Liabili,es are remunerated by interest which is a charge in the profit and loss account. Rank over owners in a winding up. Generally tax deduc,ble. Equity creates an ownership interest remunerated by dividends which are a distribu,on of retained profit not a charge in arriving at profit. Not tax deduc,ble. 32

33 FINANCIAL LIABILITIES (DEBT/ BORROWINGS) 33

34 Simple Bank Loan On January 1, 20X0, a company obtains a 1 million loan from its bank repayable in 5 years,me with a fixed interest rate of 6% per annum. Cash Bank Loan Interest Expense Yr Yr 1 Yr Yr0 Yr Yr 2 Yr Yr3 Yr Yr4 Yr Yr5 Yr Yr5 Yr Yr Yr Yr Yr Yr IRR 6% 34

35 Simple Bank Loan-Risks Same example as before but assume now that the market interest rate changes and increases to 8%. Borrower Lender Lender Borrower 8% 8% 6% 6% NPV 73,939-73, Yr0 1,000,000-1,000,000-1,000,000 1,000,000 Yr1-60,000 60,000 60,000-60,000 Yr2-60,000 60,000 60,000-60,000 Yr3-60,000 60,000 60,000-60,000 Yr4-60,000 60,000 60,000-60,000 Yr5-1,060,000 1,060,000 1,060,000-1,060,000 As a consequence of the rate change the Fair Value (NPV) of the loan has fallen from 1,000,000 to 926,061 resul,ng in a loss for the lender and a gain for the borrower. 35

36 Loan with annual repayments On January 1, 2008, a company obtains a 1 million loan from its bank repayable in 3 equal annual installments with a fixed interest rate of 5 % per annum. Outstanding Interest Loan Date Capital 5% Repayment Payments Formula r a = V 0 x (1+r) -n V 0 = Borrowed amount r = Interest rate n = number of periods a = 1,000,000 x = 367,208 1 ( ) -3 36

37 Bond with a Premium and Issuance Expenses On January 1, 2008, a company issues 1,000 Bonds. The Bonds are issued at a price of 950 for a nominal value of 1,000 and with a fixed interest rate of 6%. They are reimbursable on December 31, Issuing fees, for an amount of 47,000 have been deducted from the proceeds of the offering. Yr Yr Yr Yr Yr IRR 8,99% 37

38 Bond example cont d Date Effec,ve Interest Amor,za,on Amor,zed Interest Paid Cost 9% 6%

39 Debt instrument at amor,zed cost - example Amor?zed cost, Effec?ve interest rate method Fixed interest, fixed term instruments At the end of 2013 a company purchases a debt instrument with five years remaining to maturity for its fair value of US$ 1,000 (including transac,on costs). The instrument has a principal amount of US$ 1,250 and carries fixed interest of 4.7% payable annually (US$ 1,250 x4.7% = US$ 59 per year). In order to allocate interest receipts and the ini,al discount over the terms of the instrument at a constant rate on the carrying amount, it can be shown that the interest needs to be accrued at the rate of 10% annually. The table below provides informa,on about the amor,zed cost, interest income and cash flows of the debt instrument in each repor,ng period. (a) (b = a x 10%) ( c ) (d = a + b - c) Nominal amount US $ Interest rate 4,70% Amor,zed cost at Interest Cash Amor,zed cost at start of year income Flows end of year IRR US$ US$ US$ US$ (1,250+59) 0 10,0% 39

40 EQUITY FINANCE 40

41 Equity Finance Defini,on: An equity instrument is any contract that evidences a residual interest in the assets of an en9ty amer deduc9ng all its liabili9es. An instrument is an equity instrument if, and only if, both condi,ons (a) and (b) below are met. a) The instrument includes no contractual obliga,on: i. To deliver cash or another financial asset to another en,ty; or ii. To exchange financial assets or financial liabili,es with another en,ty under condi,ons that are poten,ally unfavorable to the issuer. b) If the instrument will or may be seiled in the issuer s own equity instruments, it is: i. A non-deriva,ve that includes no contractual obliga,on fro the issuer to deliver a variable number of its own equity instruments; or ii. A deriva,ve that will be seiled only by the issuer exchanging a fixed amount of cash or another financial asset for a number of its own equity instrument. For this purpose, rights, op,ons or warrants to acquire a fixed number of the en,,es own equity instruments for a fixed amount of any currency are equity instruments if the en,ty offers the rights, op,ons or warrants pro rata to all of its exis,ng owners of the same class of its own non-deriva,ve equity instruments. 41

42 Equity increases Share Capital can be increased by: Cash contribu,ons by exis,ng or new owners Non-cash contribu,ons Conversion of retained earnings Conversion of conver,ble bonds Share Capital can be decreased by: Acquisi,on of own shares (Treasury shares) Capital reduc,on (Normally court approval required) Absorp,on of losses 42

43 Equity Instruments Non-puiable ordinary shares Some puiable ordinary shares Some instruments that impose on the en,ty an obliga,on to deliver to another party a pro rata share of the net assets of the en,ty on liquida,on. Some types of preference shares Warrants or wriien call op,ons that allow the holder to subscribe for or purchase a fixed number of non-puiable ordinary shares A puiable financial instrument includes a contractual obliga,on to repurchase or redeem that instrument for cash or another financial asset on exercise of the put. Excep,on if it has all of five features set out in the standard See the three condi,ons in the standard A preference share that provides for mandatory redemp,on by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or aeer a par,cular date for a fixed or determinable amount, is a financial liability. 43

44 COMPOUND FINANCIAL INSTRUMENTS 44

45 Compound Financial Instruments An en,ty recognizes separately the components of a financial instrument that: a) Creates a financial liability of the en,ty and; b) Grants an op,on to the holder of the instrument to convert it into an equity instrument of the en,ty. 1. Determine FV of the liability component 1. Financial liability 2. Equity instrument e.g. call op,on 2. FV of the whole instrument* less FV of liability component Conver,ble Bond (Right, for a specified 9me, to convert into a fixed number of ordinary shares of the issuer) * Normally the considera,on received when issued 45

46 RISK MANAGEMENT 46

47 Risk Management Credit risk The risk that one party to a financial instrument will cause a loss for the other party by failing to discharge an obliga,on Liquidity risk The risk that an en,ty will encounter difficulty in mee,ng obliga,ons associated with that are seiled by delivering or another Market risk The risk that the fair value of future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three types of risk: Currency risk - the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates Interest rate risk the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates Other price risk The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than interest rate risk or currency risk), e.g. commodity prices or equity instruments, whether those changes are caused by factors specific to the individual financial instrument or its issuer or by factors affec,ng all similar financial instruments traded in the market. 47

48 Deriva,ve A deriva,ve is a financial instrument or other contract with all of the following characteris,cs: a) Its value changes in response to the change in a specified interest rate (e.g.libor), financial instrument price (e.g. share price), commodity price (e.g. price of a barrel of oil), foreign exchange rate (e.g. /$ spot rate), index of prices or rates (e.g. CPI), a credit ra,ng (e.g. Fitch) or credit index (e.g. AAA rated corporate bond index), or other variable, provided in the case of a non-financial variable (e.g. index of earthquake losses or temperatures) that the variable is not specific to a party to the contract (some,mes called the underlying) b) It requires no ini,al net investment, or an ini,al net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors ( e.g. an op,on, currency swap); and c) It is seiled at a future date 48

49 Deriva,ves - examples Type of contract Swaps: Interest rate, Currency, Commodity, Equity, Credit, Total return Op,ons: (Purchased or wriien) bonds, currency, stock op,ons Futures: Interest rate, currency, commodity Forwards: Interest rate, currency, commodity, equity Main pricing-seilement underlying variable Interest rates, currency rates, commodity prices, equity prices, credit ra,ng, Total fair value of the reference asset and interest rates 49

50 Hedging Fair value hedges Gain or loss on re-measuring to FV recorded in P&L to offset change in value of hedged item Cash flow hedges Por,on determined to be an effec,ve hedge recorded in OCI and the ineffec,ve por,on in P&L. Transfer to P&L in the period the hedged transac,on impacts net income Net investment hedges Similar to cash flow hedges. Reclassified to P&L on disposal Change in value of specific assets or liabili,es or firm commitment e.g. risk of change in interest rates for a fixed rate bond. Future forecast cash flows e.g. future interest payments or exchange risk for a future transac,on Currency risk on investments in foreign subsidiaries N.B. In order to apply hedge accoun,ng all the hedge accoun,ng condi,ons must be met 50

51 Hedge accoun,ng condi,ons Hedge Formal designa,on at incep,on fully documented Or Expected to be highly effec,ve For cash flow hedges a forecast transac,on must be highly probable Specula?on The effec,veness can be reliably measured The hedge is assessed on an on-going basis 51

52 EXAMPLES 52

53 Example interest rate risk Interest rate 6% 5% 4% Fixed rate vs. floa,ng rate debt Floa,ng rate or variable rate Fixed rate P1 P2 P3 P4 How can we hedge the risks? What are the implica9ons for the debt instrument? Risks Cash flow: Increase/decrease in interest expense Fair value: Increase/decrease in FV of debt instrument 53

54 Interest Rate Swap A agrees to pay B 7% on a no,onal 1 million A Borrows 1 million LIBOR + 2% Interest rate swap B Borrows 1 million Fixed 8% SWAP B agrees to pay A LIBOR + % on a no,onal 1 million SWAP Pays 70,000 Receives 5+1% 60,000 Net 10,000 P1 5+2% 70,000 10,000 80,000 LIBOR 5% P1 80,000 (10,000) 70,000 Receives 70,000 Pays 5+1% 60,000 Net 10,000 Pays 70,000 Receives 4+1% 50,000 20,000 P2 4+2% 60,000 20,000 80,000 LIBOR 4% P2 80,000 (20,000) 60,000 Receives 70,000 Pays 4+1% 50,000 20,000 Pays 70,000 Receives 6+1% 70,000 0 P3 6+2% 80, ,000 LIBOR 6% P3 80, ,000 Receives 70,000 Pays 6+1% 70,000 0 Pays 70,000 Receives 8+1% 90,000 (20,000) P4 8+2% 100,000 (20,000) 80,000 LIBOR 8% P4 80,000 20, ,000 Receives 70,000 Pays 8+1% 90,000 (20,000) A is concerned interest rates will rise and wants to swap variable for fixed B is concerned interest rates will fall and wants to swap fixed for variable 54

55 Fair Value Hedge Jones Company issues $1,000,000 5 Year 8% fixed rate bonds on 2 January Jones is concerned that if market interest rates decline, the fair value of the liability to the company will increase. To protect against this Jones decides to hedge the risk entering into a 5 Year Interest Rate Swap contract. The Terms of the swap contract are: 1. Jones will receive fixed payments of 8% 2. Jones will pay variable rates based on market rates(currently 6.8%) Jones has therefore changed the fixed rate loan to variable Variable 6.8% Swap Counter-party Jones pays variable Rate of 6.8% Jones receives fixed Rate of 8% Fixed 8% Jones Company Jones pays fixed Rate of 8% Fixed 8% Bond investors Swap Contract Bond payable Yr 0 1,000,000 1,050,000 Yr 1-80,000-80,000 Yr 2-80,000-80,000 Yr 3-80,000-80,000 Yr 4-80,000-80,000 Yr 5-1,080,000-1,080,000 IRR 8.0% 6.8% Risk is also that if interest rates fall the fair value of the liability will increase Source: Wiley Accoun,ng for Deriva,ve Instruments 55

56 FV Hedge Accoun,ng January Dr Cash 1,000,000 Cr Bonds payable 1,000,000 January Memorandum that swap contract is signed No value so no entry December 31 Dr interest expense 80,000 Cr Cash 80,000 Interest due on the bond (1,000,000 x 8%) December 31 Dr Cash 12,000 Interest rates have declined so the value of the swap contract has increased to 40,000 Cr Interest expense 12,000 ( Proceeds from swap contract Net 8% = 80,000 received less 6.8% = 68,000 paid) December 31 Dr Swap contract (B/S) 40,000 Cr Financial income 40,000 To record the value of the swap contract December 31 Dr Financial expense 40,000 Cr Bonds Payable 40,000 To record the increase in the FV of the bond Net interest expense is 68,000 i.e. variable Increase in FV of bond is exactly offset by the increase in value of the swap contract 56

57 Example currency risk Exchange rate 1 US$ = Rate at the date of sales order Rate at the date of invoicing US$ / Exchange rate Rate at the date of collec,on What are the accoun9ng entries? P1 P2 P3 P4 Transac,on Sale of 100,000 unit at $10 each. At date of order $ 1.3 = 1,300,000 An,cipated sales proceeds At date of invoicing $ 1.2 = 1,200,000 Difference of 100,000 is a business loss At date of collec,on $ 1.1 = 1,100,000 Difference of 100,000 is a business loss and an accoun,ng loss. 57

58 Cash Flow Hedge In September 2000 Allied Can Co. an,cipates purchasing 1,000 metric tons of aluminum in January It is concerned that prices will rise so to hedge that risk it enters into an aluminum futures contract to purchase 1,000 metric tons for $1,550 a metric ton in January At the date of the contract if the value of the contract equals the spot price the op,on has no value. At December 31, 2000 the price of aluminum for delivery in January has increased to $1,575 per metric ton. December 31, 2000 January 2001 Dr Futures contract 25,000 Cr OCI 25,000 (($1,575 - $ 1550) x 1,000 tons)) Dr Aluminum Inventory 1,575,000 Cr Cash 1,575,000 ( $1,575 x 1,000 tons) January 2001 Dr Cash 25,000 Cr Futures contract 25,000 ($1,575,000 1,550,000) When sold Dr OCI 25,000 Cr Cost of goods sold 25,000 Anticipated Cash Flows Wish to fix cash paid for inventory at $1,550,000 = Actuald Cash Flows Actual cash paid $1,575,000 Less: Cash received On futures contract (25,000) Final cash paid $1,550,000 58

59 Contract date Market price $ 2,500 Concerned prices will fall Aluminium Producer (1) Futures/Forwards Both want to hedge their exposure to price changes Futures Contract Producer agrees to sell 1 ton of aluminium in 3 moths,me for $ 2,500 a ton Concerned prices will rise Car Manufacturer If both par,es decide One month later Market price $ 3,000 Loss $500 they want to get out of Profit $500 the contract they can t tear up the contract, but they can Novate i.e. replace the contract with another Aluminium Producer (2) Car Manufacturer Concerned this may just be a price spike and wants to lock in his profit Trader 1 Manufacturer agrees to sell 1 ton of aluminium in 2 moths,me for $ 3,000 a ton Trader 2 Three months later Contract 1. Producer buys at $3,000 and sells at $2,500 incurring a loss of $500 Market price $ 3,000 Contract 2. Manufacturer sells to Producer 2 at $3,000 who sells to Producer 1 at $3,000 Source: Money Week Investment Tutorials 59

60 Futures Trading Traders do not want to take delivery. No product or goods changes hands. Value of trades can far exceed the value of commodi,es available Trader C Trader A L $10 S $12 Day 1 + $ 2 Day 2 Bets that the price will rise Trader B Market Price Day 1 $10 Day 2 $12 Day 3 $ 14 Bets that the price will fall S $10 L $14 $ (4) Day 3 L $12 S $14 + $ 2 Also bets that the price will rise Long = Buys Short = Sells Source: Money Week Investment Tutorials 60

61 Op,ons Uses (Deriva,ves) Specula,ve (Gambling) Hedging (Risk Management) The Writer of the op,on sets the price. Put/Call op,on Right to sell/buy 1,000 ABC shares at 400p each during the next three months (Expiry date) Strike price Op9ons are are normally sold for a Premium Call op,on: call to the writer i.e. to buy Put op,on: put to the writer i.e. sell 61

62 Call Op,on - example Call op,on Right to buy 1,000 ABC shares at 400p each during the next three months (Expiry date) Market price 375p Two weeks later Premium paid = 30 p per share i.e. 300 (Similari9es to an insurance premium) Op,on holder calls the op,on 1,000 shares 400 Seller has to buy 4,000 share 450 Holder sells the shares for 450 Strike price (400) Premium paid (30) Profit for op,on holder 20 Market price 450p If the market price had fallen to 300 the op,on would not have been exercised. Call op,ons make money if price rises (bullish), put op,ons if prices fall (bearish) Op,ons can be traded and prices fluctuate with changes in the underlying 62

63 Purchases of goods in foreign currency 1. a) On September 30, 20X0 a company buys 10,000 units of product $2 each i.e. $20,000. b) It records this transac,on in at the exchange rate at the,me of the transac,on i.e. 1.2 = 16, c) At year end, December 31, the balance is s,ll outstanding therefore the company restates the liability at the year end rate i.e. 1.3 = 15, d) The difference of 1, is credited to income. Inventory Accounts Payable , , ,67 $ Sept ,00 1, ,67 Dec ,00 1, , ,05 Exchange Differences (I/S) 1.282,05 Exchange rates September 30 20X0 1 = $1.2 December 31 20X0 1 = $1.3 63

64 Sale of goods in foreign currency 2. a) On September 30, 20X0 the company sells 50,000 units of product X to a customer in the USA at $10 each i.e. $500,000. b) It records this transac,on in at the exchange rate at the,me of the transac,on i.e. 1.2 or 416, c) At year end, December 31, the balance is s,ll outstanding therefore the company restates the receivable at the year end rate i.e. 1.3 or 384, d) The loss of 32, is debited to the income statement. Accounts receivable Sales , ,38 416, Exchange Differences (I/S) ,38 $ Sept ,00 1, ,67 Dec ,00 1, , ,28 64

65 Net Investment Country/ Currency Subsidiary A Subsidiary B Subsidiary C USA $ Switzerland CHF Italy Assets 10,000,000 5,000,000 2,500,000 Liabili,es (7,000,000) (3,000,000) (2,000,000) Net Assets 3,000,000 2,000,000 1,500,000 Exchange Rate XO Exchange Rate X0 Transla,on difference Parent Company Italy 1 = $1.3 1 = CHF 1.0 N/A 1 = $1.2 1 = CHF 1.3 N/A Gain 192,308 Loss 461,539 N/A 65

66 Net Investment Hedge Country/ Currency Subsidiary A Subsidiary B Subsidiary C USA $ Switzerland CHF Italy Assets 10,000,000 5,000,000 2,500,000 Liabili,es (7,000,000) (3,000,000) (2,000,000) Net Assets $ 3,000,000 CHF 2,000,000 1,500,000 Possible Hedges Parent Company Bank Loan Parent Company Italy N/A $ (3,000,000) CHF (2,000,000) N/A Currency forwards $ (3,000,000) CHF (2,000,000) N/A 66

67 Loan to subsidiary in own currency 3. a) On September 30 20X0 a company makes a loan to its subsidiary in the USA of 1,000,000 b) The subsidiary records this transac,on in $ at the exchange rate at the,me of the transac,on i.e. 1.2 or 1,200,000 c) At year end, December 31, the balance is s,ll outstanding therefore the subsidiary company restates the liability at the year end rate i.e. 1.3 or $1,300,000 d) The difference of $100,000 is debited to income by the subsidiary. Subsidiary Parent Co Loan payable $ Loan Receivable , , ,00 Exchange differences $ ,00 0,00 $ Sept ,00 1, ,00 Dec ,00 1, , ,00 0,00 67

68 Loan to a subsidiary in foreign currency 4. a) On September 30 20X0 the company makes a loan to its subsidiary in the USA of $ 1,200,000 b) The parent company records this transac,on in at the exchange rate at the,me of the transac,on i.e. 1.2 or 1,000,000 c) At year end, December 31, the balance is s,ll outstanding therefore the parent company restates the receivable at the year end rate i.e. 1.3 or 923, d) The parent company debits the difference to the income statement unless this loan is considered to be part of the repor,ng en,ty s net investment in a foreign opera,on in which case it is taken to OCI. Subsidiary Parent Co Loan payable $ Loan Receivable , , ,08 Exchange differences (P&L) ,08 OCI $ ,08 Sept ,00 1, ,00 Dec ,00 1, ,92 0, ,08 Treatment depends on whether the loan is intended to be repaid. If the loan is considered to be more like equity financing the difference is taken to OCI 68

69 Transla,on of financial statements 5. a) Exchange differences arising on transla,on of a subsidiary s financial statements are taken to OCI. b) Assuming a situa,on in which the subsidiary made neither profit or loss in the period. Sept 30 XO Exchange Dec 31 X0 Exchange $ Rate $ Rate Assets ,00 1, , ,00 1, ,54 Liabili,es ,00 1, , ,00 1, ,77 Net assets ,00 1, , ,00 1, ,77 Loss on exchange to OCI on consolida,on ,56 69

70 DISCLOSURES RELATING TO FINANCIAL INSTRUMENTS 70

71 Disclosures relating to financial instruments IFRS7 requires many detailed disclosures relating to financial instruments. The main purpose of these disclosures is to enable users to evaluate the significance of financial instruments for the entity's financial position and performance. Disclosures are also required which will enable users to evaluate the nature and extent of any risk related to financial instruments. 71

72 Unilever an example (¼) Management of market risk Unilever s size and opera,ons result in it being exposed to the following market risks that arise from its use of financial instrument: Commodity price risk Currency risk Interest rate risk The above risks may affect the Group s income and expenses, or the value of its financial instruments. The objec,ve of the Group s management of market risk is to maintain this risk within acceptable parameters, while op,mizing returns. Generally, the Group applies hedge accoun,ng to manage the vola,lity in profit and loss arising from market risk. 72

73 Example Unilever Group (2/4) Poten?al impact of risk Management policy and hedging strategy Sensi?vity to the risk i) Commodity price risk The group is exposed to the risk of changes in commodity prices in rela,on to its purchase of certain raw materials. At the Group has hedged its exposure to future commodity purchases for 197 million with commodity deriva,ves. ii) Currency risk Currency risk on sales, purchase and borrowings Because of Unilever s global reach, it is subject to the risk that changes in foreign currency values impact the group s sales, purchases and borrowings At the un-hedged exposure to the Group from companies holding financial assets and liabili,es other than in their func,onal currency amounted to 76 million. The group uses commodity forward contracts to hedge against this risk. All commodity forward contracts hedge future purchases of raw materials and the contracts are seiled either in cash or by physical delivery. Commodity deriva,ves are generally designed as hedging instruments in cash flow hedge accoun,ng rela,onships. The Group manages currency exposures within prescribed limits, mainly through the use of forward currency exchange contracts. Opera,ng companies manage foreign exchange exposures within prescribed limits. Local compliance is monitored centrally. Exchange risks related to the principal amounts of the US$ and Swiss Franc denominated debt either form part of hedging rela,onships themselves, or are hedged through forward contracts. The aim of the Group s approach to management of currency risk is to leave the group with no material residual risk. This aim has been achieved. A 10 % increase in commodity prices as at would have led to a 18 million gain on the commodity deriva,ves in the cash flow hedge reserve. A decrease of 10 % in commodity prices on a full-year basis would have the equal opposite effect. As an es,ma,on of the approximate impact of the residual risk, with respect to financial instruments, the Group has calculated the impact of a 10% change in exchange rates A 10 % strengthening of the euro against key currencies to which the group is exposed would have led to approximately an addi,onal 8 million gain in the income statement. A 10% weakening of the euro against these currencies would have led to an equal but opposite effect. 73

74 Example Unilever Group (3/4) Poten?al impact of risk Management policy and hedging strategy Sensi?vity to the risk Currency risk on the Group s net investments The Group is also subject to the exchange risk in rela,on to the transla,on of the net assets of its foreign opera,ons into euros for inclusion in its consolidated financial statements. These net investments include Group financial loans which are monetary items that form part of our net investment in foreign opera,ons, of 7.0 billion of which 4.0 billion is denominated in GBP. In accordance with IAS 21 the exchange differences on these financial loans are booked through reserves. Part of the currency exposure on the Group s investments is also managed using net investment hedges with a nominal value of 2.7 billion. Most of these hedges were US$ contracts. At December 31, 2014 the net exposure of the net investments in foreign currencies amounts to 10.4 billion. Unilever aims to minimize this foreign investment exchange risk by borrowing in local currency in the opera,ng companies themselves. In some loca,ons, however, the Group s ability to do this is inhibited by local regula,ons, lack of local liquidity or by local market condi,ons. Where residual risk from these countries exceeds prescribed limits, Treasury may decide on a caseby-case basis to ac,vely hedge the exposure. This is done either trough addi,onal borrowings in the related currency, or through the use of forward foreign exchange contracts. Where local currency borrowings, or forward contracts, are used to hedge the currency risk in rela,on to the Group s net investment in foreign subsidiaries, these rela,onships are designated as net investment hedges for accoun,ng purposes. A 10 % strengthening of the euro against all other currencies would have led to 946 million nega,ve transla,on effect. A 10 % weakening of the euro against these currencies would have had led to a 1,157 million posi,ve retransla,on effect. In line with accepted hedge accoun,ng treatment and our accoun,ng policy for financial loans, the retransla,on differences would be recognized in equity. 74

75 Example Unilever Group (4/4) Poten?al impact of risk Management policy and hedging strategy Sensi?vity to the risk iii) Interest rate risk The Group is exposed to market interest rate fluctua,ons on its floa,ng rate debt. Increases in benchmark interest rates could increase the interest cost of our floa,ng-rate debt and increase the cost of future borrowings. The Group s ability to manage interest costs also has an impact on results. Taking into account the impact of interest rate swaps, at , interest rates were fixed on approximately 70% of the expected net debt for 2015 and 67% for The average interest rate on short-term borrowings in 2014 was 1.2%. Unilever s interest rate management approach aims for an op,mal balance between fixed and floa,ng-rate interest rate exposures on expected net debt. The objec,ve of this is to minimize annual interest costs aeer tax and to reduce vola,lity. This is achieved either by issuing fixed or floa,ngrate long-term debt, or by modifying interest rate exposure through the use of interest rate swaps. Furthermore, Unilever has interest rate swaps for which cash flow hedge accoun,ng is applied. Assuming that all other variables remain the constant, 1.0 percentage point increase in floa,ng interest rates on a full-year basis as at would have led to an addi,onal 26 million of finance costs. A 1.0 percentage point decrease in floa,ng interest rates on a full-year basis would have an equal but opposite effect. Assuming that all other variables remain constant, a 1.0 percentage point increase in floa,ng interest rates on a full-year basis as at would have led to an addi,onal 39 million credit in equity from deriva,ves in cash flow hedge rela,onships. A 1.0 percentage point decrease in floa,ng interest rates on a full-year basis would have led to an addi,onal 42 million debit in equity from deriva,ves in cash flow hedge rela,onships. 75

76 REQUIRED READING AND ASSIGNMENT FOR NEXT SESSION 76

77 Overview of Session 8 Tangible Fixed Assets Acquired vs constructed Capital vs. revenue expenditures Interest Government Grants Deprecia,on Revalua,ons Leasing - briefly 77

78 Session 8 Pre-work Reading Melville Interna,onal Financial A prac,cal Guide: Chapter 5 Property, plant and equipment IASB Statements IAS 16 Property, Plant and Equipment IASB Technical summaries IAS 17 Leases Research Iden,fy the nature of the Tangible Fixed Assets in your chosen company and how they are classified and accounted for. Exercises Melville exercises , Plus On-line mul,ple choice ques,ons for chapter 11 Exercises EX 7 Non-current Financial Assets and Liabili,es 78

79 SUMMARY AND VALIDATION 79

80 Overview of Session 7 Financial Instruments Non-deriva,ve/Deriva,ve Fair Value (P&L vs OCI), Amor,zed Cost Risk Management: Liquidity, Counterparty, Market (Price, interest rate, currency) Hedging (Fair Value, Cash Flow, Net Investment) Accoun,ng See also SM 7.1 Deriva,ves and Hedging Primer SM 7.2 Financial Instruments - Examples 80

81 Other Comprehensive Income 81

82 Session 7 Valida,on What is a financial instrument? What three market risks do financial instruments expose a company to? How should financial instruments be ini,ally measured? How should they be subsequently measured? What are the three main types of hedge used by companies to manage risk? 82