Financial Instruments

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What is meant by "Financial Instrument"?

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A real or virtual document representing a legal agreement involving some sort of monetary value.

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What are the types of financial instruments?

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1- Cash, foreign currency, & demand deposits

2- Evidence of an ownership interest in an entity

3- Contracts which result in an exchange of cash or ownership interest in an entity (ex. Bonds)

4- Derivatives, ex. OFFS (Options, Futures, Forwards, Swaps)

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On specified election dates, entities MAY choose to measure eligible financial instruments at FV.

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Under the FVO, un realized gains & losses are reported in EARNINGS.

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The FVO is IRREVOCABLE & is applied to INDIVIDUAL financial instruments.

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If a company elects the FV option for a financial instrument, it must continue to use FV measurement for that instrument until the company no longer owns this instrument.

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If the company does not elect the FV option for a given financial instrument at the date of recognition, it may not use this option on that specific instrument in subsequent periods.

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Entities may elect the FVO for recognized financial assets & financial liabilities. For example, an entity can choose to measure at FV an investment that would otherwise be classified as AFS, with un realized gains & losses recorded in EARNINGS rather than in OCI, Or an entity can choose to measure at FV an investment that would otherwise be accounted for using the equity method.

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What are the financial instruments that are NOT eligible for the FVO?

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1- Investments in subsidiaries or VIEs that an entity is required to consolidate,

2- Pension benefit assets or liabilities,

3- Financial assets or liabilities recognized under leases,

4- Deposit liabilities of financial institutions,

5- Financial instruments classified as equity.

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The FVO may only be applied on certain dates

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What are the FVO election dates that ONLY it can be applied on?

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1- The date that an entity first recognizes an eligible financial instrument,

2- The date that an investment becomes subject to equity method accounting,

3- The date that an entity ceases to consolidate an investment in a subsidiary or VIE.

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Under IFRS, the FVO can only be elected for financial assets if doing so eliminates or significantly reduces a measurement or recognition "inconsistency" that would otherwise arise from measuring assets or liabilities or recognizing the gains & losses on them on different bases.

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What are the conditions that if one of them exist the FVO can be elected for financial liabilities measurement under IFRS?

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1- Doing so eliminates or significantly reduces a measurement or recognition "inconsistency" that would otherwise arise from measuring assets or liabilities or recognizing the gains & losses on them on different bases, OR

2- A group of financial liabilities or financial assets & financial liabilities is managed & its performance is evaluated on a FV basis (in accordance with a documented risk management or investment strategy) & information about the group is provided internally on that basis to the entity's key management personnel.

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FVs must be disclosed for all financial instruments for which it is practicable to estimate that value, together with the related CVs showing clearly whether the amounts represent assets or liabilities.

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The financial instruments FV disclosure should state the method(s) & significant assumptions used to estimate FV & a description of any changes in method(s) & significant assumptions during the period.

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What are the issues that should be disclosed if its not practicable to estimate the FV of the financial instruments?

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1- Information pertinent to estimating the FV of the financial instrument

2- The reasons why it is not practicable to estimate FV

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Under U.S. GAAP, financial instruments FV disclosures apply to all entities (except non-public entities that have total assets less than $100 million & have no instruments that are accounted for as derivatives).

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What is meant by "Credit Risk"?

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It is the possibility of loss from the failure of another party to perform according to the terms of a contract.

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A concentration of credit risk occurs when an entity has contracts of material value with one or more parties in the same industry or region or having similar economic characteristics (e.g., a group of highly leveraged entities).

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Entities must disclose all significant concentrations of credit risk arising from all financial instruments, whether from:

1- Single party, or

2- Group of parties engaged in similar activities & that have similar economic characteristics.

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Under US GAAP, Disclosure of "all significant concentrations of credit risk arising from all financial instruments" apply to all entities (except non-public entities that have total assets less than $100 million & have no instruments that are accounted for as derivatives)

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What is meant by "Market Risk"?

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It is the possibility of loss from changes in market value (not necessarily due to the failure of another party, but due to changes in economic circumstances).

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Under U.S. GAAP, all entities are ENCOURAGED, but not required, to disclose QUANTITATIVE information (about the market risk of financial instruments) that is consistent with the way it manages or adjusts those risks.

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IFRS REQUIRES disclosure of the nature & extent of risks arising from financial instruments, including disclosure of credit risk for each class of financial instrument, disclosure of liquidity risk, & disclosure of market risk.

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The market risk disclosure is NOT optional under IFRS.

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What is meant by "Derivative Instrument"?

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It is a financial instrument that "derives" its value from the value of some other instrument.

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A derivative instrument has One or more underlyings & one or more notional amounts or payment provisions (or both), &

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A "derivative instrument" requires no initial net investment or one that is smaller than would be required for other types of similar contracts.

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A "derivative instrument" terms require or permit a net settlement or it can readily be settled net outside the contract (e.g., on an exchange) or by delivery of an asset that gives substantially the same results (e.g., an asset readily convertible to cash).

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A "derivative instrument" can be settled for cash in lieu of physical delivery

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What is meant by an "Underlying of a derivative"?

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It is a specified price, rate, or other variable (e.g., interest rate, security or commodity price, FOREX rate, index of prices or rates, etc.), including a scheduled event (e.g., a payment under contract) that may or may not occur.

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What is meant by a "Notional amount of a derivative"?

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It is a specified unit of measure (e.g., currency units, shares, bushels, pounds, etc.).

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What is the "Value or settlement amount of a derivative"?

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It is the amount determined by the multiplication (or other arithmetical interaction) of the notional amount & the underlying. For example, shares of stock times the price per share.

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What is the "Derivative Payment Provision"?

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It is a specified (fixed) or determinable settlement that is to be made if the underlying behaves in a specified way.

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What is meant by "Hedging"?

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It is the use of a derivative to offset anticipated losses or to reduce earnings volatility.

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When a hedge is effective, the change in the value of the derivative offsets the change in value of a hedged item or the cash flows of the hedged item.

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What are the common Derivatives?

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1- Option Contract

2- Futures Contract

3- Forward Contract

4- Swap Contract

OFFS

Front 38

What is meant by "Option Contract"?

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It is a contract between two parties that gives one party the right, but not the obligation, to buy or sell something to the other party at a specified price during a specified period of time.

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The option buyer, or holder, must pay a premium to the option seller, or writer, to enter into the option contract.

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What is meant by a "Call Option"?

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It is an option that gives the holder the right to BUY from the option writer at a specified price during a specified period of time.

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What is meant by a "Put Option"?

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It is an option that gives the holder the right to sell to the option writer at a specified price during a specified period of time.

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What is meant by "Futures contract"?

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It is an agreement between two parties to exchange a commodity or currency at a specified price on a specified future date.

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In the "Futures Contract" One party takes a long position & agrees to buy a particular item while the other party takes a short position & agrees to sell that item.

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What is meant by "Futures contract Long Position"?

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It is the buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value.

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What is meant by "Futures contract Short Position"?

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It is the sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value.

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Unlike an option , both parties of the Futures contract are OBLIGATED to perform according to the terms of the contract.

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Futures contracts are made through a clearing house (Publicly traded) & have standardized notional amounts & settlement dates.

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Forward contracts are similar to futures contracts, EXCEPT that they are privately negotiated between two parties with the assistance of an intermediary, rather than through a clearinghouse (Privately Traded).

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Forward contracts do not have standardized notional amounts or settlement dates.

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The terms of a forward contract are established by the parties to the contract.

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What is meant by a "Swap Contract"?

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It is a private agreement between two parties, generally assisted by an intermediary, to exchange future cash payments.

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What are the common Swaps?

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1- Interest rate swaps,

2- Currency swaps,

3- Equity swaps,

4- Commodity swaps.

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A swap agreement is equivalent to a series of forward contracts.

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Market risk & credit risk are the inherent risks of ALL derivative instruments.

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What is meant by "Derivative Instrument Market Risk"?

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It is the risk that the entity will incur a loss on the derivative contract.

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Derivatives are a "zero sum game" which means that every derivative has a "winner" & a "loser."

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What is meant by "Derivative Instrument Credit Risk"?

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It is the risk that the other party to the derivative contract will not perform according to the terms of the contract.

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All derivative instruments are recognized in the B/S as either assets or liabilities, depending on the rights or obligations under the contracts.

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ALL derivative instruments are measured at FV.

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Accounting for changes in the FV of a derivative is dependent on whether the derivative has been designated as (& whether it qualifies as) a hedge, combined with the reason for holding the instrument.

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Gains / losses on a derivative instrument not designated as a hedging instrument are recognized currently in EARNINGS, similar to the accounting for trading securities.

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What are the types of Hedges?

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1- FV hedge

2- Cash flow hedge

3- Foreign currency hedge

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What is the "FV Hedge"?

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It is an instrument designated as a hedge of the exposure to changes in FV of:

1- A recognized asset or liability, or

2- An unrecognized firm commitment, that are relates to a particular risk.

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Gains / losses on FV hedge as well as the offsetting gain / loss on the hedged item are recognized in EARNINGS in the same accounting period, even if changes in FV of the hedged item are normally reported in OCI. (ex. The hedged item may be an AFS security, in this case, adjustment of its CV due to a change in its FV must be recognized as a gain / loss in earnings (Not OCI)

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The FV hedge derivative instrument must be expected to be highly effective in offsetting the FV change (that could affect income) of the hedged item.

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What is the "Cash flow Hedge"?

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It is an instrument designated as mitigating the risk of variability in the cash flows of:

1- A recognized asset or liability, OR

2- A forecasted transaction that relates to a specified risk.

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Gains / losses on the INEFFECTIVE portion of a cash flow hedge are reported in current income.

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Gains / losses on the EFFECTIVE portion of a cash flow hedge are deferred & are reported as a component of OCI until the hedged transaction impacts earnings,

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If a forecasted sale or expense is hedged, the gain / loss in AOCI is reclassified to earnings when the sale or expense is recognized in earnings.

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If a forecasted inventory purchase is hedged, the gain / loss in AOCI is reclassified to earnings when the inventory is sold to customers.

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If a forecasted fixed asset purchase is hedged, the gain / loss in AOCI is reclassified to earnings as the fixed asset is depreciated.

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If an existing asset or liability is hedged, the gain / loss in AOCI is reclassified to earnings when the asset or liability impact earnings.

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Gains or losses from FV hedge is recognized in EARNINGS because it is designated as a hedge of the exposure to changes in FV of transactions that had ALREADY been occurred (ex. Unrecognized firm commitment), while Gains or losses from the effective portion of Cash flow hedge is recognized in OCI because it is designated as mitigating the risk of variability in the cash flows of transactions that are FORECASTED.

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A forecasted transaction is probable, i.e. expected to occur, although no firm commitment exists. It does not:

1- Provide current rights, OR

2- Impose a current obligation because no transaction or event has occurred.

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What is the "Foreign Currency Hedge"?

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It is an instrument designated as hedging the exposure to variability in foreign currency in a variety of foreign currency transactions.

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What are the 3 types of foreign currency hedge?

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1- FV hedge

2- Cash flow hedge

3- Net investment hedge

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Gains & losses from changes in the FV of foreign currency transaction hedges classified as FV hedges are accounted for in the same manner as gains / losses on other FV hedges - in earnings.

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Gains & losses from changes in the FV of foreign currency transaction hedges classified as cash flow hedges are accounted for in the same manner as gains / losses on cash flow hedges - in OCI for the effective portion & current income for the ineffective portion.

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A U.S. firm that maintains an equity investment in a foreign company may enter into a foreign currency transaction or a non-derivative financial instrument in an effort to minimize or offset the effects of currency fluctuations on the net investment.

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Gains & losses from changes in the FV of foreign currency transaction hedges entered into to hedge a net investment in a foreign operation are reported in OCI as part of the cumulative translation adjustment for the effective portion & current income for the ineffective portion.

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Cash flows from a derivative with NO hedging designation should be accounted for in INVESTING activities, unless the derivative is held for trading purposes.

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If a derivative with NO hedging designation is held for trading purposes, the cash flows should be accounted for in OPERATING activities.

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The cash flows from a derivative held as a hedge may be accounted for in the same category as the item being hedged, which means that If the derivative contains a significant FINANCING element at inception (which is often a matter of judgment), all cash flows associated with that derivative should be reported as cash flows from FINANCING activities, not just those related to the financing element.

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What would be the JE to record the loss from FV fluctuation of a firm purchase commitment?

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What would be the JE to record the gain from FV hedge used to mitigate the loss resulting from the fluctuations of FV of a firm purchase commitment?

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What would be the JE to record the net settlement of the forward contract FV hedge?

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What would be the JE to record the settlement of the firm purchase commitment?

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What would be the JE to record the gain from Cash flow hedge?

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What would be the JE to record the net settlement of the forward contract Cash flow hedge?

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US GAAP & IFRS have similar disclosure requirements.

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A description of the entity's objectives for holding or issuing derivatives & its strategies to achieve those objectives should be disclosed.

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Information should be disclosed about each instrument's primary underlying risk exposure (interest rate, credit, FOREX rate, or overall price).

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Derivatives should be distinguished (in the FN disclosure) between those used for risk management (hedging) & those used for other purposes.

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Derivatives that are used for hedging purposes should be designated as:

1- FV hedging instruments,

2- Cash flow hedging instruments, or

3- Instruments hedging the foreign currency exposure of a net investment in a foreign operation.

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If a derivative is not designated as a hedging instrument, then the purpose of the derivative should be described in the FN disclosure.

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Information on the volume of the company's derivative activity should be disclosed.

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FV of derivative instruments must be presented on a gross basis.

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FV of derivative instruments must be presented as separate asset & liability values segregated between:

1- Derivatives used for hedging purposes, &

2- Derivatives that are not used for hedging purposes.

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The disclosure of the derivative instruments should include the line items in the B/S in which the FV amounts are included.

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The location (line items) & amount of the gains & losses reported on the I/S & OCI of derivative instruments should be disclosed.

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What are the issues that Gains & Losses should be presented separately for?

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1- FV hedges.

2- The effective portion of gains & losses on cash flow hedges & net investment hedges recognized in OCI during the current period.

3- The effective portion of gains & losses on cash flow hedges & net investment hedges reclassified from OCI to the I/S during the current period.

4- The ineffective portion of the gains & losses on cash flow hedges & net investment hedges.

5- Derivative instruments not designated as hedges.

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What are the issues that should be disclosed for derivatives designated as FV hedges & the related hedged items,?

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1- Net gain or loss recognized in earnings during the current period,

2- Effective portion of the hedge, &

3- The portion of the gain or loss (if any) excluded from the assessment of effectiveness.

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What are the issues that should be disclosed for derivatives designated as cash flow hedges & the related hedged items,?

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1- Description of the events that will result in reclassification of gains & losses from OCI to earnings,

2- Estimated reclassification adjustments for the next 12 months,

3- Estimated length of time over which the future cash flows will be hedged

4- Amount of gains & losses reclassified to earnings because the forecasted cash flows will not occur & the cash flows hedge has been discontinued

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Certain financial instruments have characteristics of both liabilities & equity, should be classified as liabilities.

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What are those financial instruments that have characteristics of both liabilities & equity, & should be classified as liabilities?

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1- Financial instruments in the form of shares that are mandatorily redeemable

2- Financial instruments, other than outstanding shares, that represent an obligation to repurchase the issuer's equity shares by transferring assets.

3- Financial instruments that represent an obligation to issue a variable number of shares.

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Under IFRS 9, financial assets are initially recognized at FV & then subsequently measured at either amortized cost or FV.

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Under IFRS, Financial assets that are debt instruments are reported at amortized cost or FV.

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Under IFRS, What are the conditions that should ALL met in order for a financial asset that is a debt instrument to be measured at the amortized cost?

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1- The asset is held in a business model whose objective is to hold assets in order to collect contractual cash flows, &

2- The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal & interest.

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Under IFRS, If the conditions for amortized cost measurement are not met or the entity elects at initial recognition to designate the debt instrument as measured at FV through profit or loss, the debt instrument is reported at FV with gains & losses recognized in earnings.

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Under IFRS, A financial asset that is an equity instrument is reported at FV with gains & losses recognized in earnings

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Under IFRS, What are the conditions that should one of them exist in order for a financial asset that is an equity instrument NOT to be measured at FV?

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1- It is part of a hedging relationship

2- The entity makes an irrevocable election on initial recognition to present gains & losses in OCI.

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Under IFRS, Gains & losses recognized in OCI are NEVER recognized in earnings, but may be reclassified within equity.

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Under IFRS, Reclassification of financial assets between amortized cost & FV are required only when the entity changes the business model under which it manages financial instruments. Such changes should be infrequent & are accounted for PROSPECTIVELY, which means that the asset should be remeasured at FV on the date of the reclassification, with any gain or loss recognized in earnings.

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Under IFRS 9, financial liabilities are INITIALLY recognized at FV & then SUBSEQUENTLY measured at either amortized cost or FV.

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Under IFRS, In general, financial liabilities are subsequently measured at amortized cost using the effective interest method.

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Under IFRS, Financial liabilities may be subsequently measured at FV in certain circumstances, such as when an entity at initial recognition irrevocably designates a financial liability as measured at FV through profit or loss.

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Under IFRS, Gains & losses on financial liabilities measured at FV are recognized in earnings, unless the entity is required to present the effects of changes in the liability's credit risk in OCI.

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Under IFRS, Financial liabilities may NOT be reclassified between amortized cost & FV.