Chapter 15
Accounting for
financial instruments
.
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Objectives of this lecture
• Understand what a financial instrument is
• Be able to describe various types of financial instruments
• Understand the difference between a primary financial
instrument and a derivative financial instrument
• Understand how to measure a financial instrument
• Understand that some derivative financial instruments
can significantly increase the risk exposure of an
organisation, and so appreciate the necessity for full
disclosure in relation to such instruments
.
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Objectives (cont.)
• Understand what a compound financial
instrument is and how the debt and equity
components of a compound equity instrument are to
be determined
• Understand the requirements of AASB 7 Financial
Instruments: Disclosure; AASB 132 Financial
Instruments: Presentation and AASB 139 Financial
Instruments: Recognition and Measurement
• Be able to provide accounting entries for various
types of futures contracts, options, swap agreements
and compound financial instruments
.
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Relevant accounting standards
There are three standards that are of direct
importance to this lecture, these being:
1. AASB 7 Financial Instruments: Disclosure
2. AASB 132 Financial Instruments: Presentation
3. AASB 139 Financial Instruments: Recognition and
Measurement
.
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Financial instruments defined
• A financial instrument (AASB 132) is:
– any contract that gives rise to both a financial asset of
one entity and a financial liability or equity instrument
of another entity
• A financial asset (AASB 132) would include:
– cash, or
– a contractual right to receive cash or another financial
asset from another entity, or
– a contractual right to exchange financial instruments
with another entity under conditions that are potentially
favourable, or
– an equity instrument of another entity
.
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Financial instruments defined (cont.)
•
A financial liability (AASB 132) would include:
– any liability that is a contractual obligation
 to deliver cash or another financial asset to another
entity; or
 to exchange financial assets or liabilities with another
entity under conditions that are potentially unfavourable;
or
– a contract that will or may be settled in the entity’s own
equity instruments and
 is a derivative that will or may be settled other than by
the exchange of a fixed amount of cash or another
financial asset for a fixed number of the entity’s own
equity instruments
.
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Financial instruments defined (cont.)
A financial liability (AASB 132) would include (cont.):
– a contract that will or may be settled in the entity’s own
equity instruments and (cont.)
 is a non-derivative for which the entity is or may be
obliged to deliver a variable number of the entity’s own
equity instruments
• An equity instrument (AASB 132) is:
– any contract that evidences a residual interest in the assets
of another entity after deduction of all its liabilities
.
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Financial instruments defined (cont.)
• Central to the definition is whether or not a
‘contractual obligation’ exists
– If there is no contractual obligation to deliver cash or
another financial asset, or to exchange another
financial instrument under conditions that are
potentially unfavourable, it is considered to be an
equity instrument
– What does ‘unfavourable’ mean in this context? See
Worked Example 15.1 (p. 465), which shows how the
issue of share options creates a financial asset in the
accounts of the holder of the options, and a financial
liability in the accounts of the issuer
– In the context of the issue of options, the likelihood of
the option being exercised does not impact on its
classification as a financial liability
.
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Financial instruments defined (cont.)
• Examples of financial instruments
–
–
–
–
–
–
–
–
.
cash at bank
bank overdrafts
term deposits
trade receivables and payables
investments
options
forward foreign exchange agreements
foreign currency swaps
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Financial instruments defined (cont.)
• Primary financial instruments:
– include receivables, payables and equity securities
such as ordinary shares—accounting treatment fairly
straightforward
• Derivative financial instruments
– create rights and obligations with the effect of
transferring one or more of the financial risks inherent
in an underlying primary financial instrument
– include financial options, futures, forward contracts
and interest rate and currency swaps
• Refer to Worked Example 15.2 (p. 467)—Derivative
financial instrument
.
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Debt versus equity components of
financial instruments
• The issuer of a financial instrument must determine
whether to disclose it as a liability or equity (AASB
132)
– They are required to consider economic substance
rather than just the legal form
• Critical feature in differentiating financial liability from
equity is the existence of a contractual obligation on
the part of one entity either to deliver cash or another
financial asset, or to exchange another financial
instrument
.
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Debt versus equity components of
financial instruments (cont.)
• Preference shares
– If there is an option to redeem the shares for cash,
should be debt rather than equity
– When distributions to shareholders are at the issuer’s
discretion, shares are equity
• If classified as debt, then periodic payments are
classified as interest expenses, which will affect
profits. If classified as equity, then the payments
are dividends and will not impact on reported
profits
.
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Debt versus equity components of
financial instruments (cont.)
• Convertible notes
– Debt giving the holder the right to convert securities
into the issuer’s ordinary shares
– Often classified as compound financial instruments,
containing both a financial liability and equity
component
– Debt and equity components to be accounted for and
disclosed separately
• Where an instrument is classified as debt (a
liability) the related interest can sometimes be
treated as part of the cost of an asset under
construction
.
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Debt versus equity components of
financial instruments (cont.)
• Instruments cannot be reclassified after initial
recognition unless:
– their substance is altered by a transaction or other
specific action by the issuer (AASB 132)
• The AASB Framework allows reclassifications
based on revised probabilities (however,
accounting standards take precedence)
• Determine fair value of liability component and
equity component as the residual
.
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Measurement of financial instruments
• According to AASB 139:
– financial instruments are generally to be measured at
fair value, with some exceptions
• Categories of financial instruments (AASB 139)
– Financial asset or financial liability at fair value through
profit or loss
– Held-to-maturity investments
– Loans and receivables
– Available-for-sale financial assets
.
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Financial asset or financial liability at fair
value through profit or loss
• Financial asset or financial liability at fair value
through profit or loss if (AASB 139):
– classified as held for trading, or
– upon initial recognition it is designated by entity as at
fair value through profit or loss
• Periodic adjustments to fair value go to profit or loss
• Investments in equity investments that do not have a
quoted market price in an active market, and whose
fair value cannot be reliably measured, shall not be
designated as at fair value through profit or loss
.
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Available-for-sale financial assets
• Includes all financial assets that don’t fall into
other categories
• Equity investments to be measured at fair value
• Changes in fair value recognised in equity until
financial asset is derecognised (perhaps as a
result of a sale) at which time the changes in fair
value are transferred out of equity and
recognised in the profit or loss as a
‘reclassification adjustment’
.
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Loans and receivables and held-to-maturity
investments
• To be measured at amortised cost using the
effective-interest method
AASB 139 provides the following definition of the effectiveinterest method:
The effective interest method is a method of calculating the
amortised cost of a financial asset or a financial liability (or
group of financial assets or financial liabilities) and of allocating
the interest income or interest expense over the relevant period.
The effective interest rate is the rate that exactly discounts
estimated future cash payments or receipts through the
expected life of the financial instrument or, when appropriate, a
shorter period to the net carrying amount of the financial asset
or financial liability
.
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Loans and receivables and held-to-maturity
investments (cont.)
• If an impairment loss has been incurred, the amount
of the loss is calculated as (AASB 139):
– the difference between the asset’s carrying amount and the
present value of estimated future cash flows with:
 the carrying amount to be reduced directly or through an
allowance account
 the loss to be recognised in profit or loss
.
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Other financial liabilities
• To be recognised at amortised cost using effectiveinterest method subsequent to initial measurement
(AASB 139)
• Refer to Worked Example 15.3 (p. 475)—Financial
liabilities other than those measured at fair value
.
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Worked Example 15.3—Financial liabilities other than
those measured at fair value
On 1 July 2010, Slater Ltd issued four-year bonds with a total face
value of $100 000 and a coupon interest rate of 10% per annum,
payable annually in arrears. The market interest rate for Slater’s
bonds was 12% and so the company had to discount the issue
price to its fair value of $93 923
.
Beginning
bond
payable
Year ended
($)
Interest
payment
($)
Interest at
12% (column
2 × 12%)
($)
06/11
06/12
06/13
06/14
10 000
10 000
10 000
10 000
11 272
11 423
11 594
11 788
93 923
95 195
96 618
98 212
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Increase in
bond payable
(column 4 –
column 3)
($)
Amortised
cost of bond
payable
(column 2 +
column 5)
($)
1 272
1 423
1 594
1 788
95 195
96 618
98 212
100 000
15-21
Worked Example 15.3—Financial liabilities other than
those measured at fair value (cont.)
1 July 2010
Dr
Cash
93 293
Cr
Bond payable
(issue of bonds for $93 293)
93 293
30 June 2011
Dr
Interest expense
11 272
Cr
Bond payable
1 272
Cr
Bank
10 000
(interest payment and amortisation of bond payable
using effective-interest rate of 12%)
.
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Derivative financial instruments
• Can include:
–
–
–
–
–
futures contracts
options contracts
interest rate swaps
foreign currency swaps
forward-rate contracts
• To be recognised initially at fair value (AASB 139)
• The value of a derivative is directly related to
another item, for example a share option derives
its value from the market value of the underlying
shares
.
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Derivatives used within a hedging
arrangement
•
•
Derivatives often used to hedge gains or losses in future
in relation to other assets or liabilities
Hedge contract
– Arrangement with another party in which that party accepts
the risks associated with changing commodity prices or
exchange rates
•
Three principal types of hedges (AASB 139)
1. Fair value hedges
2. Cash-flow hedges
3. Hedges of net investments in foreign operations
•
•
.
Need to differentiate between hedged item and
hedging instrument
Refer to Worked Example 15.4 (p. 476)—Hedging
arrangement
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Derivatives used within a hedging
arrangement (cont.)
• Fair value hedge
– Used to hedge the value of particular assets or
liabilities
• Cash-flow hedge
– Used to hedge a future expected cash flow
• Unless certain strict requirements are satisfied
(AASB 139):
– any gain or loss on hedging instrument to be taken to
profit or loss as it arises
.
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Derivatives used within a hedging
arrangement (cont.)
• Tests for hedge effectiveness
– At inception of hedge and throughout its life, hedge
must be ‘highly effective’
– As measured each financial period, hedge is deemed
to be highly effective so that actual results are
between 80 and 125%
• Fair value hedge
– Both hedged item and hedging instrument to be
measured at fair value
– Any gains or losses to be included as part of profit or
loss
.
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Derivatives used within a hedging
arrangement (cont.)
• Cash-flow hedge
– Gain or loss on measuring hedged item at fair value is
to be part of period’s profit or loss
– Gain or loss on hedging instrument initially transferred
to equity (and included as part of ‘other
comprehensive income’), then transferred to profit or
loss to offset gains or losses on hedged item
.
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Worked Example 15.6—Cash flow hedge relating to the
purchase of inventory
• Oz Ltd manufactures electric cars.
• On 15 June 2011 Oz Ltd enters into a non-cancellable purchase
commitment with Vegas Ltd for the supply of batteries, with those
batteries to be shipped on 30 June 2011
• The total contract price was US$ 2 000 000 and the full amount
was due for payment on 30 August 2011
• Because of concerns about movements in foreign exchange rates,
on 15 June 2011 Oz Ltd entered into a forward rate contract on US
dollars with a foreign exchange broker so as to receive US$ 2 000
000 on 30 August 2011 at a forward rate of $A1.00 = US$0.80
(meaning A$ 2 500 000 will be payable to the foreign currency
broker)
• We will assume that Oz Ltd prepares monthly financial statements
and that it elects to treat the hedge as a cash flow hedge
• Further, we will assume that Oz Ltd elects, pursuant to paragraph
98(b) of AASB 139, to adjust the cost of the inventory as a result of
the hedging transaction
.
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Worked Example 15.6—Cash flow hedge relating to the
purchase of inventory (cont.)
The respective spot rates, with the spot rates being the exchange
rates for immediate delivery of currencies to be exchanged, are
provided below. The forward rates offered on particular dates, for
delivery of US dollars on 30 August 2011, are also provided.
On 30 August 2011, the last day of the forward rate contract, the
spot rate and the forward rate will be the same.
Forward rates for 30 August
Date
Spot rate
delivery of US$
15 June 2011
$A1.00 = US$0.83
$A1.00 = US$0.80
30 June 2011
$A1.00 = US$0.81
$A1.00 = US$0.78
31 July 2011
$A1.00 = US$0.80
$A1.00 = US$0.77
30 Aug. 2011
$A1.00 = US$0.76
$A1.00 = US$0.76
.
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Worked Example 15.6—Solution
Given this has been designated as a cash flow hedge, and it has
also been assumed that the hedge is ‘effective’, then any gains or
losses on the hedging instrument shall initially be recognised in
equity (and therefore in ‘other comprehensive income’) and then
ultimately transferred to the cost of inventory.
Gains/Losses on the hedged item (inventory) are calculated as
follows:
Amount payable
Foreign exchange
Date
15 June 2011
30 June 2011
31 July 2011
Spot rate
$A1.00 = US$0.83
$A1.00 = US$0.81
$A1.00 = US$0.80
in $A
–
$2 469 136
$2 500 000
gain/(loss)
30 Aug. 2011
$A1.00 = US$0.76
$2 631 579
(131 579)
(30 864)
(162 443)
.
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Worked Example 15.6—Solution (cont.)
Gains/Losses on the hedging instrument (the forward rate
contract) are calculated as follows:
Date
15/6/2011
30/6/2011
31/7/2011
30/8/2011
.
Fwd rate for Receivable on Amount payable
delivery of US$
fwd contract in A$ on forward.
on 30 Aug 2011
contract
$A1.00 = US$0.80
$2 500 000
$2 500 000
$A1.00 = US$0.78
$2 564 103
$2 500 000
$A1.00 = US$0.77
$2 597 403
$2 500 000
$A1.00 = US$0.76
$2 631 579
$2 500 000
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Fair value Gain/(loss) on
of forward
forward
contract
contract
0
$64 103
$64 103
$97 403
$33 300
$131 579
$34 176
$131 579
15-31
Worked Example 15.6—Solution (cont.)
30 June 2011
Dr Forward rate contract
64 103
Cr Gain recorded in equity (other comprehensive income)
Dr
Cr
Inventory
Foreign currency payable
Dr
Cr
Gain recorded in equity (other comprehensive income) 64 103
Inventory
64 103
2 469 136
2 469 136
64 103
Following the date of acquisition of the inventory all gains and losses on the forward
rate contract and the foreign currency payable with the supplier are transferred
directly to profit or loss just as they would be for a fair value hedge
31 July 2011
Dr Forward rate contract
Cr Foreign exchange gain
Dr Foreign exchange loss
Cr Foreign currency payable
.
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33 300
33 300
30 864
30 864
15-32
Worked Example 15.6—Solution (cont.)
30 August 2011
Dr Forward rate contract
Cr Foreign exchange gain
34 176
34 176
Dr
Cr
Foreign exchange loss
Foreign currency payable
131 579
Dr
Cr
Cash at bank
Forward rate contract
131 579
131 579
131 579
Dr Foreign currency payable
2 631 579
Cr Cash at bank
2 631 579
(this represents the amount paid to the overseas battery supplier. As we
can see from the above two entries, the net amount paid for the batteries
was $2 500 000 (which is $2 631 579 – $131 579), which equates to the
amount negotiated in the forward rate contract)
.
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Futures contracts
• A contract to buy or sell an agreed quantity of a
particular item, at an agreed price, on a specific
date
• Buy or sell price determined on date contract
entered into
• First futures contracts introduced in 1960 in
Australia for greasy wool
• Majority of trading volume now relates to financial
futures
– Result in the ultimate transfer of cash or another
financial instrument
.
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Futures contracts (cont.)
• Financial futures currently traded
–
–
–
–
–
90-day bank bill futures
3-year bond futures
10-year bond futures
share price index futures (SPI futures)
futures for shares in specific companies
• Huge losses (or gains) can be made on the futures
market
• Refer to Worked Examples 15.5, Fair value hedge
(p. 478), and 15.6, Cash-flow hedge relating to the
purchase of inventory (p. 479)
.
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Futures contracts (cont.)
• Share price index (SPI) futures
– Based on, e.g., market prices of top 200 companies
and on performance of top 50 companies
– Directly related to the All Ordinaries SPI
– May be used for hedging purposes or speculation
• Refer to Worked Example 15.8 (p. 484)—Futures
trading taking a buy position
.
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Journal entries for SPI futures
• To make a percentage deposit with a futures
broker
Debit
Deposit on SPI futures
Credit
Cash at bank
• To ‘mark to market’ the value of the organisation’s
share portfolio
Debit
•
To credit gains to the initial deposit held by the
futures broker
Debit
.
Loss on share portfolio
Credit
Share portfolio
Deposit held by broker
Credit
Gain on futures contract
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Journal entries for SPI futures (cont.)
• If shares are sold and futures contract is closed
out
.
Debit
Debit
Cash
Loss on share portfolio
Credit
Share portfolio
Debit
Deposit held by broker
Credit
Gain on futures contract
Debit
Cash at bank
Credit
Deposit held by broker
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Journal entries for currency futures
• Refer to Worked Example 15.10 (p. 486)—Use of
currency futures
• To record sale at spot rate
Debit
Debit
Accounts receivable
Cost of goods sold
Credit
Sales revenue
Credit
Inventory
• To record deposit made with futures broker
Debit
.
Deposit on futures contract
Credit
Cash at bank
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Journal entries for currency futures
(cont.)
• To record receipt from overseas purchaser
Debit
Debit
Cash at bank
Loss on foreign exchange
Credit
Accounts receivable
• To record gain on futures contract
Debit
.
Deposit with futures broker
Credit
Gain on futures contract
(equity)
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Journal entries for currency futures
(cont.)
• To transfer gain from equity to offset loss on
hedged item
Debit
Gain on futures contract (equity)
Credit
Gain on futures contract
(in profit or loss)
• To record receipt of original deposit and gains on
contract
Debit
.
Cash at bank
Credit
Deposit with futures broker
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Options
• Put options
– Give their holder the right to sell an asset, at a
specified exercise price, on or before a specified date
– Value of option depends on market price of underlying
security
• Call options
– Give their holder the right to buy an asset, at a
specified exercise price, on or before a specified date
.
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Options (cont.)
• Exercise price
– The price the option holder will pay to buy a
company’s shares
• Once the exercise price is determined, it remains
fixed, regardless of variations in the market price
of shares
• When an option is acquired on the ASX, an
amount is paid for it
• The holder of the option has the right to exercise
the option, but typically does not have to do so
• Options are to be measured at fair value, with
changes included as part of profit or loss
.
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Journal entries for options
• Refer to Worked Example 15.11 (p. 489)—
Valuation of options at net market price
• To record investment in share options
Debit
Investment in share options
Credit
Cash at bank
• To value share options at fair value
Debit
.
Investment in share options
Credit
Profit on share options
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Swaps
• Swap agreement
– An agreement between borrowers to exchange
aspects of their respective loan obligations
• Commonly used swaps
– Interest rate swaps
– Foreign currency swaps
.
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Swaps (cont.)
• Foreign currency swaps
– Obligation relating to a loan in one currency is
swapped for that of a loan in another currency
– Used when entity has receivables and payables both
denominated in a different foreign currency
– Used to hedge against effects of changes in exchange
rates
– Entity seeks another entity that is prepared to swap its
foreign currency loans for the entity’s domestic loans
– Primary borrower still has commitment to primary
lender should the other party to the swap default on
the arrangement
.
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Worked Example 15.12—Foreign currency swap
• On 1 July 2011 Byron Ltd, an Australian company, borrows US$2
million at a rate of 12% from a US corporation, repayable in US
dollars. The loan is for a period of three years. Byron Ltd trades
predominantly within Australia
• At the same time, Watego Ltd, also an Australian company,
borrows A$2.5 million from an Australian bank, also at a fixed
rate of 12% and also for a period of three years.
• Watego Ltd also has a number of receivables denominated in US
dollars.
• As a result of perceived benefits to both parties, Byron Ltd and
Watego Ltd decide to enter a swap contract in which they
effectively swap their interest and principal obligations on the
same date they take out the loans, that is 1 July 2011.
• From Byron Ltd’s perspective this means that as a result of the
swap contract the overall net position will be that it will incur a
net-total interest expense each period of $300 000 each year,
regardless of what happens to exchange rates, and will also
make a loan repayment of $2 500 000 at the end of three years
regardless of what happens to exchange rates
.
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Worked Example 15.12—Foreign currency swap
(cont.)
• We will assume that the required market rates on both
loans are equal to the coupon rates, that is they are
also 12% and we will further assume that the market
rates remain at 12% throughout the term of the loans.
• Cash payments related to each loan are to be made on
30 June of each year. The relevant exchange rates are:
.
1 July 2011
A$1.00 = US$0.80
30 June 2012
A$1.00 = US$0.70
30 June 2013
A$1.00 = US$0.75
30 June 2014
A$1.00 = US$0.77
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PPTs to accompany Deegan, Australian Financial Accounting 6e
15-48
Worked Example 15.12—Solution
It is assumed that the entity has elected to account for the swap as a cash-flow
hedge. As the gains and losses on the hedged item (the loan) and the hedging
instrument (the swap) fully offset each other, the net effect on equity or profits is
$nil. The foreign loan is considered to be perfectly hedged. Hence the gains and
losses on the swap agreement shall be taken directly to profit or loss as they arise
and will represent the change in the fair value of the swap agreement.
Date
1/7/11
30/6/12
Fair value of the
Fair value of foreign currency Australian payable
receivable component of swap component of swap*
[(2 000 000 ÷ 0.8) × 0.12 ×
2.401831]+ [(2 000 000 ÷ 0.8) ×
0.7117801] = 2 500 000
2 500 000
[(2 000 000 ÷ 0.70) × 0.12 ×
1.6900509] + [(2 000 000 ÷ 0.70) ×
0.7971938] = 2 857143
306//13 [(2 000 000 ÷ 0.75) × 0.12 × 0.8928571]
+ [(2 000 000 ÷ 0.75) × 0.8928571] = 2 666 667
Fair value
of swap
Gain/(loss)
on hedge
–
–
2 500 000
357 143
357 143
2 500 000
166 667
(190 476)
30/6/14
2 000 000 ÷ 0.77 = 2 597 403
2 500 000
97 403
(69 264)
*Because the interest paid on the Australian loan (the coupon rate) is 12%, which also matches
the required market rate, the face value of the loan also equates to the present value—that is,
there is no premium or discount on the loan
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
15-49
Worked Example 15.12—Solution (cont.)
We will account for the swap agreement and the overseas loan separately
1 July 2011
Dr Cash
2 500 000
Cr Foreign loan
2 500 000
(to recognise, at the 1 July 2011 spot rate, the initial loan received from the US
company of $2 500 000 = $2 000 000 ÷ 0.80)
There is no entry to recognise the swap as the fair value of the swap agreement is
deemed to be zero on 1 July 2011, as shown in the table on the previous slide.
30 June 2012
Dr Foreign exchange loss
357 143
Cr Foreign loan
(to recognise the loss on the loan with the US corporation)
Value of loan as at 1 July 2011 2 000 000 ÷ 0.80 =
2 500 000
Value of loan as at 30 June 2012 2 000 000 ÷ 0.70 =
2 857 143
Foreign exchange loss
357 143
357 143
Dr Swap
357 143
Cr Gain on swap contract
357 143
(to recognise the gain on the swap contract negotiated with Watego Ltd—see table
above. The swap would be considered to represent a financial asset)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
15-50
Worked Example 15.12—Solution (cont.)
As we can see above, the change in the fair value of the swap
contract exactly equals the exchange loss on the foreign loan,
meaning that the overseas loan is perfectly hedged. While this
might be designated as a cash-flow hedge, meaning that gains or
loss on the hedging contract (the swap agreement in this case)
shall initially go to equity, because the gains or losses on the
hedge contract will match the gains or losses on the foreign loan,
any gains on the hedging contract shall be taken directly to profit
or loss such that the total foreign exchange gain or loss will be
zero.
Dr Interest expense
342 857
Cr Cash
342 857
Dr Cash
Cr Interest expense
.
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PPTs to accompany Deegan, Australian Financial Accounting 6e
42 857
42 857
15-51
Worked Example 15.12—Solution (cont.)
30 June 2013
Dr Foreign loan
Cr Foreign exchange gain
190 476
Value of loan as at 1 July 2012 2 000 000 ÷ 0.70 =
Value of loan as at 30 June 2013 2 000 000 ÷ 0.75 =
Foreign exchange gain
190 476
2 857 143
2 666 667
190 476
Dr Loss on swap contract
190 476
Cr Swap
190 476
(to recognise the loss on the swap contract negotiated with
Watego Ltd—see table provided earlier)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
15-52
Worked Example 15.12—Solution (cont.)
Dr Interest expense
320 000
Cr Cash
320 000
[to recognise the payment made to the US corporation of
285 714 = (2 000 000 × 0.12) ÷ 0.75]
Dr Cash
20 000
Cr Interest expense
20 000
30 June 2014
Dr Foreign Loan
Cr Foreign exchange gain
69 264
69 264
(to recognise the loss on the loan with the US corporation)
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
15-53
Worked Example 15.12—Solution (cont.)
Value of loan as at 1 July 2013 2 000 000 ÷ 0.75 =
2 666 667
Value of loan as at 30 June 2014 2 000 000 ÷ 0.77 =
2 597 403
Foreign exchange gain
69 264
Dr Loss on swap contract
69 264
Cr Swap
69 264
(to recognise the loss on the swap contract negotiated with
Watego Ltd—see table provided earlier)
Dr Interest expense
311 688
Cr Cash
311 688
[to recognise the payment made to the US corporation of 311 688
= (2 000 000 × 0.12) ÷ 0.77]
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
15-54
Worked Example 15.12—Solution (cont.)
Dr
Cr
Cash
Interest expense
11 688
11 688
Dr Loan
2 597 403
Cr Cash
2 597 403
(repayment of overseas loan)
Dr Cash
97 403
Cr Swap
97 403
(to recognise the completion of the swap contract and to record the
amount paid to Byron Ltd by Watego Ltd)
The effect of the above two entries is that Byron Ltd will make a
net payment of $2 500 000, which equals the commitment relating
to the Australian loan
.
Copyright  2010 McGraw-Hill Australia Pty Ltd
PPTs to accompany Deegan, Australian Financial Accounting 6e
15-55
Swaps (cont.)
• Interest rate swaps
– One party exchanges interest payments of a specified
amount with another party
– Generally involves swapping variable or floating
interest rate payments for a fixed interest rate
obligation
– For a swap to proceed both parties need to receive
benefits in the form of a reduction in total interest
payments
• Refer to Worked Example 15.14 (p. 495)—Interest
rate swap
.
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15-56
Compound instruments
• Contain both a financial liability and an equity
component
• Include convertible notes
– Similar to convertible bonds, except less formal in the
absence of a detailed deed
• AASB 132 requires:
– equity component to be fair value of the whole
instrument less fair value of the liability component,
that is the equity component is the residual measure
• The AASB Framework considers perceived
probabilities of conversion:
– differently from AASB 132
.
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15-57
Journal entries for compound instruments
• Refer to Worked Example 15.15 (p. 542)—Accounting for
compound instruments
• To record the issue of the convertible bonds
Debit
Cash at bank
Credit
Convertible bonds (liability)
Credit
Convertible bonds (equity)
The liability component is determined by calculating the
present value of the future cash flows at the market’s
required rate of return based on ‘instruments of comparable
credit status and providing substantially the same cash
flows, on the same terms, but without the conversion option’
(AASB 132)
• To recognise interest expense
Debit
Interest expense
Credit
Cash
Credit
Convertible bonds (liability)
Interest expense equals the present value of the opening
liability multiplied by the market rate of interest
.
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Journal entries for compound
instruments (cont.)
If option holders elect to convert options to ordinary
shares
• To recognise interest expense
Debit
Interest expense
Credit
Cash
Credit
Convertible bonds (liability)
• To recognise conversion of bonds into shares
Debit
Debit
.
Convertible bonds (liability)
Convertible bonds (equity)
Credit
Share capital
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Disclosure requirements
• Large number of detailed disclosure requirements
in AASB 7
– A direct consequence of large losses incurred by
many organisations
• Purpose of AASB 7’s disclosure requirements to:
– enhance understanding of significance of financial
instruments, and
– assist in assessing amounts, timing and certainty of
cash flows
.
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15-60
Disclosure requirements (cont.)
• Numerous disclosure requirements in AASB 7—best
way to appreciate the extensive nature of the
disclosures is to review the standard
• Interesting to see that there are various disclosures
related to the ‘risks’ associated with financial
instruments (pars 32–42)
• Risks to be disclosed relate to:
– credit risk (the risk that one party to a financial instrument
will cause a financial loss for the other party by failing to
discharge an obligation)
– liquidity risk (the risk that an entity will encounter difficulty
in meeting obligations associated with financial liabilities)
– market risk (the risk that the fair value or future cash flows
of a financial instrument will fluctuate because of changes
in market prices)
.
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15-61
Summary
• The lecture addresses issues associated with financial
instruments
• ‘Financial instruments’ includes a wide range of items
– Can be classified as primary or derivative
• AASB 7 provides many disclosure requirements for
financial instruments
• AASB 132 provides guidance for determining whether a
financial instrument is a financial liability or an equity
instrument
• AASB 139 provides requirements for recognition and
measurement of financial instruments
.
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15-62