Illustrative Examples on Financial Instruments We Passionately Develop Quality Programmes

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1 Illustrative Examples on Financial Instruments Date 12 November 2014 Time 19:00 21:00 Venue 35/F, Central Plaza Disclaimer The materials of this seminar are intended only to provide general information on the subject concerned and shall not be relied upon for technical advice. ZHONGHUI ANDA and the speakers take no responsibility for any errors or omissions in, or for the loss incurred by individuals or companies due to the use of, the materials of this seminar. No claims, actions or legal proceedings in connection with this seminar brought by any individuals or companies having reference to the materials of this seminar will be entertained by ZHONGHUI ANDA and the speakers. Any unauthorized audio and video recordings of this seminar without the consent of the speakers are strictly prohibited, and represent a copyright violation.

2 Some Definitions under HKAS 32 & 39 3 HKAS 39.9 Amortised cost of financial asset or liability is the amount at which the item is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method Effective interest method is a method of calculating amortised cost Effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through expected life of the instrument. The calculation includes all fees and points paid or received, transaction costs, and all other premiums or discounts 4

3 HKAS 39 IG B.26 Example of calculating amortised cost A purchases a debt instrument with five years maturity for CU1,000 (including transaction costs). The instrument has a principal amount of CU1,250 and carries fixed interest of 4.7 per cent that is paid annually (CU1,250 x 4.7% = CU59). In order to allocate interest receipts and initial discount over the term of the debt instrument at a constant rate on the carrying amount, they must be accrued at the rate of 10 per cent annually. 5 The table below provides information about the amortised cost, interest income and cash flows of the debt instrument in each reporting period. Year (a) (b = a x 10%) (c) (d = a + b - c) Amortised cost at year beginning Interest income Cash flows Amortised cost at year end 1 1, , , , , , , , , ,

4 HKAS (fixed to fixed rule) Equity instrument if, and only if, both conditions (a) and (b) are met. a. The instrument includes no contractual obligation to deliver cash or another financial asset; or to exchange financial assets or liabilities under conditions unfavourable. b. If the instrument settled in own equity instruments, it is: non-derivative includes no contractual obligation to deliver variable number of own equity instruments; or derivative settled by exchanging fixed amount of cash or another financial asset for fixed number of own equity instruments. 7 IFRIC Guidance in April 2005 Classification of instruments as liabilities or equity depends upon whether a fixed amount of foreign currency represents fixed amount of cash or other financial asset Any obligation denominated in foreign currency represents variable amount of cash Consequently, contracts settled by delivering fixed number of own equity instruments in exchange for fixed amount of foreign currency should be classified as liabilities 8

5 Convertible Loans 9 Two common types of convertible loans Loan holders have options to cash repayment or share conversion Ignore other derivatives HKAS Compound instrument = liability component + equity conversion option HKAS Hybrid (Combined) instrument = liability component + derivative conversion option 10

6 HKFRS Requirements for Convertible Loans 11 Compound Instruments HKAS When compound instrument is initially allocated, equity component is assigned residual amount after deducting from FV of instrument amount for liability component Value of any derivative features (such as call option) embedded other than equity component is included in liability component Sum of amounts assigned to liability and equity components on initial recognition is always equal to FV of instrument as a whole No gain or loss on initial recognition 12

7 HKAS First determine amount of liability component by measuring FV of similar liability without associated equity component HKAS 32.AG31(a) On initial recognition, FV of liability component is present value of contractually determined stream of future cash flows discounted at market rate of interest applied at that time to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option Equity conversion option = Total Liability component (Principal Call option) 13 HKAS 32.IE38 Proceeds received on issue of callable convertible bond are CU60. The value of a similar bond without a call or equity conversion option is CU57. Value to the entity of the embedded call feature in a similar bond without an equity conversion option is CU2. Value allocated to liability component is CU55 = CU57 CU2 Value allocated to equity component is CU5 = CU60 CU55 14

8 HKAS Initially measure at FV plus (not at FVTPL) transaction costs HKAS Changes in FV of equity instrument not recognised HKAS Normally measure financial liabilities at amortised cost using effective interest method HKAS 32.AG32 On conversion at maturity, derecognise liability component and recognise it as equity. Original equity component remains as equity (may be transferred within equity). No gain or loss on conversion at maturity HKAS Transaction costs allocated to liability and equity components in proportion to allocation of proceeds 15 Combined Instruments HKAS 39.AG28 Initial carrying amount of host instrument is residual amount after separating embedded derivative HKAS Initially measure at FV plus (not at FVTPL) transaction costs HKAS 39.55(a) Gain or loss on derivatives recognised in profit or loss HKAS Normally measure financial liabilities at amortised cost using effective interest method 16

9 Illustrative Example of Compound Instrument Convertible loan issued at par: HK$1,000,000 Conversion option meets equity and no other derivatives Transaction cost: HK$50,000 Loan period: 3 years Coupon rate: 1% p.a. (HK$10,000) Market interest rate on date of issue: 6% p.a. 17 Cash flow NPV at 6% HK$ HK$ End of year 1 (10,000) 9,434 End of year 2 (10,000) 8,900 End of year 3 (1,010,000) 848,015 FV of liability component on date of issue 866,349 Residual amount of equity component HK$1,000,000 HK$866, ,651 18

10 Transaction cost allocated to liability component HK$50,000 x 866,349 / 1,000,000 43,317 Transaction cost allocated to equity component HK$50,000 x 133,651 / 1,000,000 6,683 Initial amount of liability HK$866,349 HK$43, ,032 Amount of equity HK$133,651 HK$6, , Liability component carried at amortised cost Year (a) Amortised cost at year beginning (b = a x %) (c) (d = a + b - c) Interest expense Cash flows Amortised cost at year end 1 823,032 64,593 (10,000) 877, ,625 68,877 (10,000) 936, ,502 73,498 (1,010,000) 0 20

11 Accounting entries: Date of issue HK$ HK$ Dr. Bank 950,000 Cr. Conversion equity 126,968 Cr. Convertible loan 823,032 End of year 1 HK$ HK$ Dr. Convertible loan interest 64,593 Cr. Bank 10,000 Cr. Convertible loan 54, If conversion at end of year 1 HK$ HK$ Dr. Conversion equity 126,968 Dr. Convertible loan 877,625 Cr. Share capital and premium 1,004,593 22

12 Illustrative Example of Combined Instrument Convertible loan issued at par: HK$1,000,000 Not fixed to fixed conversion option and no other derivatives Transaction cost: HK$50,000 Loan period: 3 years Coupon rate: 1% p.a. (HK$10,000) FV of conversion derivative on date of issue: HK$100,000 FV of conversion derivative at end of year 1: HK$200, FV of conversion derivative on date of issue 100,000 Residual amount of liability component on date of issue HK$1,000,000 HK$100, ,000 Transaction cost allocated to conversion derivative HK$50,000 x 100,000 / 1,000,000 5,000 Transaction cost allocated to liability component HK$50,000 x 900,000 / 1,000,000 45,000 Initial amount of liability HK$900,000 HK$45, ,000 24

13 Liability component carried at amortised cost Year (a) Amortised cost at year beginning (b = a x %) (c) (d = a + b - c) Interest expense Cash flows Amortised cost at year end 1 855,000 55,336 (10,000) 900, ,336 58,270 (10,000) 948, ,606 61,394 (1,010,000) 0 25 Accounting entries: Date of issue HK$ HK$ Dr. Bank 950,000 Dr. Convertible loan expense 5,000 Cr. Conversion derivative liability 100,000 Cr. Convertible loan 855,000 End of year 1 HK$ HK$ Dr. Convertible loan interest 55,336 Cr. Bank 10,000 Cr. Convertible loan 45,336 26

14 End of year 1 HK$ HK$ Dr. Fair value loss 100,000 Cr. Conversion derivative liability 100,000 If conversion at end of year 1 HK$ HK$ Dr. Conversion derivative liability 200,000 Dr. Convertible loan 900,336 Cr. Share capital and premium 1,100, Accounting for Convertible Loan Holder 28

15 Conversion option HKAS 39.AG 30(f) Equity conversion feature embedded in convertible debt instrument is not closely related to the host debt instrument from perspective of holder Conversion option is therefore derivative asset i.e. at FVTPL. 29 Host contract HKAS 39.9 Loans and receivables (not quoted in active market) HKAS 39.9 & 39.55(b) Available-for-sale investment Effective interest income to profit or loss HKAS 39.11A at FVTPL (entire convertible loan) 30

16 Held-to-maturity investment??? Initial cost allocation method not mentioned in HKFRS Follow HKFRS 3.2(b) Cost allocated to identifiable assets and liabilities on basis of their relative fair values 31 32

Practical Issues on HKFRS Part III We Passionately Develop Quality Programmes

Practical Issues on HKFRS Part III Date 25 August 2015 Time 1:00 21:00 Venue Duke of Windsor Social Service Building www.zhtraining.com Disclaimer The materials of this seminar are intended only to provide