Financial instruments include primary instruments and derivative

FINANCIAL ENVIRONMENT, PART II financial instruments

FFINANCIAL INSTRUMENTS, INTEREST RATES Primary Instruments include

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AND TAXES
i. Financial assets
ii. Financial liabilities
Learning Objectives: iii. Equity instruments
1. Explain the significance of interest rates as far as the While, Derivative financial instruments include, among others
economy the transfer of funds are concerned
2. Discuss the determinants of interest rates i. Options
3. Enumerate and explain the three components of the ii. Futures and forwards
money rate of interest on loans iii. Interest rate swaps
4. Explain the nature and impact of taxes on individuals and iv. Currency swaps
business firms
5. Describe what a financial instrument is
6. Describe and give examples of primary and derivative Assets
financial instruments
These are the sources controlled by the entity as a result of
7. Distinguish between
past events and from which future economic benefits are expected to
a) Financial VS. Non-financial assets
flow to the enterprise. These resources include financial assets such
b) Financial VS. Non-financial liabilities
as cash, receivables, or debt and equity securities of other enterprises
8. Describe and give examples of derivative financial
held by the entity as the investments. They also include non-financial
instruments
assets, such as inventory, property, plant and equipment, and
intangible assets.
FINANCIAL INSTRUMENTS
Financial instruments like stocks and bonds are recorded Assets should be classified into two: current assets and non-
evidence of obligations on which exchanges of resources are current assets.
founded. The effective investment management of these financial
PAS 1, paragraph 66, provides that an entity shall classify an asset as
instruments is one of the important aspects of the financing activities
current when:
of any organization.
 a. The asset is cash or cash equivalent unless the asset is
restricted from being exchanged or used to settle a liability for
at least twelve months after the reporting period.
b. The entity holds the asset primarily for the purpose of trading
c. The entity expects to realize the asset within twelve months
after the reporting period.
d. The entity expects to realize the asset or intends to sell or
consume it within the entity’s normal operating cycle.
The line items under current assets are:
1. Cash and cash equivalents
2. Financial Assets at Fair Value such as trading securities and
other investments in quoted equity instruments
3. Trade and other receivables
4. Inventories
5. Prepaid Expenses
An entity shall classify all other assets as non-current.
Examples of non-current liabilities are:
1. Property, Plant and Equipment
2. Intangible Assets
Current Assets
Cash
From the point of view of a layman, “cash” simply means
money. Money is the standard medium of exchange in business
transactions which refers to the currency and coins which are in
circulation and legal tender.
However, in the accounting parlance, the term cash has a
special and broader meaning. Cash connotes more than money. As
contemplated in accounting, cash includes money and any other
negotiable instrument that is payable in money and acceptable by the
bank for deposit and immediate credit.
1. Cash on Hand
a. Undeposited cash collections– currencies such as
bills and coins, customers’ checks, traveller’s checks,
manager’s checks, cashier’s checks, bank drafts,
money orders.
b. Working funds– cash funds segregated for current
use in the ordinary conduct of business.
- Petty cash fund - Dividend fund
- Change fund - Tax fund
- Payroll fund - Interest fun
2. Cash in Bank– include demand deposits. There are
unrestricted funds deposited in bank that can be withdrawn
upon demand such as amounts in checking and savings
account.
Cash Equivalents
PAS 7, paragraph 6, defines cash equivalents as short term,
highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of
changes in value. It further states that “only highly liquid investments
that are acquired three months before maturity can qualify as cash
equivalents.
Receivables
The classifications of receivables in the statement of financial position
are:
1. Trade Receivables which are expected to be realized in cash
within the normal operating cycle or one year, whichever is
longer, are classified as current assets.
2. Nontrade Receivables which are expected to be realized in
cash within one year, the length of the operating cycle
notwithstanding, are classified as current assets.
If collectible beyond one year, nontrade receivables are
classified as noncurrent assets.
Accounting for Bad Debts
The two methods of accounting for bad debts are the allowance
method and direct write off method.
1. Allowance method – requires recognition of bad debt loss if
accounts are doubtful of collection.
The doubtful accounts are recorded by debiting doubtful
accounts and crediting allowance for doubtful accounts.
2. Direct Write off Method – requires recognition of bad debt loss
only when the accounts are worthless or uncollectible.
Worthless accounts are recorded by debiting bad debts and
crediting accounts receivable.
Inventories
PAS 2, paragraph 6, defines inventory as “assets which are
held for sale in the ordinary course of business; in the process of
production for such sale or in the form of materials or supplies to be
consumed in the production process or in the rendering of services.
The general rule is that all goods to which the entity has title
shall be included in inventory, regardless of location.
Two systems of Accounting for Inventories
1. Periodic or Physical system – calls for the physical counting
of goods on hand at the end of the accounting period to
determine quantities.
2. Perpetual system – requires the keeping of stock cards that
summarize inventory inflow and outflow.
The inventory cost flow assumptions acceptable under IFRS are:
a. FIFO or First in, first out
b. Weighted Average
c. Specific Identification
Prepaid Expenses
These are expenses paid by the business in advance.
Non-Current Assets a. Physical Depreciation is related to the depreciable asset’s
wear and tear and deterioration over a period.
Property, Plant and Equipment
b. Functional or economic depreciation arises from inadequacy,
These are tangible assets that are held by an enterprise for supersession and obsolescence.
use in the production or supply of goods or services, or for rental to
A variety of depreciation methods can be used to allocate the
others, or for administrative purposes and which are expected to be
depreciable amount of an asset on a systematic basis over its useful
used during more than one period.
life.
Measurement of Property, Plant and Equipment
An item of property, plant and equipment that qualifies for
Methods of Depreciation
recognition as asset shall be measured initially at cost.
1. Equal or uniform charge methods – straight line, composite
After initial recognition, an entity shall choose either the cost
method and group method
model or the revaluation model as the accounting policy and shall
2. Variable charge or use-factor methods – service hours and
apply the policy to the entire class of PPE.
output or production method
1. Cost Model – means that PPE are carried at cost less any 3. Decreasing charge or accelerated or diminishing balance
accumulated depreciation and accumulated impairment loss. methods – sum of years’ digits, declining balance and double
2. Revaluation Model – means that PPE are carried at revalued declining balance
amount, being the fair value at the date of revaluation less 4. Other methods – inventory, retirement and replacement
any subsequent accumulated depreciation and subsequent method
accumulated impairment loss.
The Straight-line Method is widely used in practice because of
its simplicity.

Depreciation Straight line depreciation is a constant charge over the useful

life of the asset.
It is the systematic allocation of the depreciable amount of the
property, plant and equipment over the useful life. Cost ( ¿ revalued amounts ) less residual value
Annual Depreciation
Estimated useful life ∈number of years
Kinds of depreciation
Illustration: Measurement of Liabilities
ABC Company acquired a machinery equipment last January Conceptually, all liabilities are initially measured at present
3, 2020 worth Php 1,000,000.00 with a residual value of Php value and subsequently measured at amortized cost. However, in
100,000.00. The estimated useful life of the said equipment is 5 years. practice, Current Liabilities or short-term obligation are not discounted
anymore but measure and reported at face amount.
The annual depreciation:
Noncurrent liabilities, for example, bond payable and
1,000,000−100,000
=180,000 noninterest-bearing note payable are initially measured at present
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value and subsequently measured at amortized cost.
To compute for the Accumulated Depreciation:
If the long term note payable is interest bearing, it is initially and
Annual Depreciation x Age of t h e PPE subsequently measured at face amount.
Intangible Assets Just like assets, the entity shall classify liabilities as current or
non-current.
PAS 38, paragraph 8, simply defines an intangible asset as an
identifiable nonmonetary asset without physical substance. The PAS 1 paragraph 69, provides that an entity shall classify a liability as
intangible asset must be controlled by the entity as a result of past current when:
event and from which future economic benefits are expected to flow to
a. The entity expects to settle the liability within the entity’s
the entity.
normal operating cycle
a. Goodwill e. Licenses b. The entity holds the liability primarily for the purpose of
b. Franchises f. Patents trading
c. Trademarks g. Copyrights c. The liability is due to be settled within twelve months after the
d. Brand names reporting period
d. The entity does not have right to defer settlement of the
liability for at least twelve months after the reporting period.
Liabilities
The line items under current liability:
These are present obligation of an entity arising from past
1. Trade and other payables
event, the settlement of which is expected to result in an outflow from
2. Current provisions
the entity o-pf resources embodying economic benefits.
 3. Short-term borrowing entity is the party who promises to pay the other party a specified
4. Current portion of long-term debt amount of money on a specified future date.
5. Current tax liability
Accrued Liabilities
All liabilities not classified as current liabilities are classified as non-
Amount owed to others for unpaid expenses.
current liabilities.
Examples of non-current liabilities are:
Unearned Revenues
1. Bonds Payable
2. Mortgage Payable When the business entity receives payment before providing
its customers with goods or services, the amount received are
recorded in the unearned revenue account (liability method). When
CURRENT LIABILITIES the goods or services are provided to the customer, the unearned
revenue is reduced, and income is recognized.
Accounts Payable
This account represents the reverse relationship of the
accounts receivable. By accepting the goods or services, the buyer Current Portion of Long-Term Debt
agrees to pay for them in the near future.
These are portions of mortgage notes, bonds and other long-
term indebtedness which are to be paid within one year from the
balance sheet date.
Note Payable
PFRS 9, paragraph 5.1.1, provides that a note payable shall
be measured initially at fair value minus transaction costs that are NON-CURRENT LIABILITIES
directly attributable to the issue of the note payable. However, if the
Bonds Payable
note payable is irrevocably designated at fair value through profit or
loss, the transaction costs are expensed immediately. Business organizations often obtain substantial sums of
money from lenders to finance the acquisition of equipment and other
It is just like a note receivable but in a reverse sense. In this
needed assets. They obtain these funds by issuing bonds. The bond
case, the business entity is the maker of the note; that is the business
is a contract between the issuer and the lender specifying the terms of date, at a predetermined price is a financial instrument that derives its
repayment and the interest to be charged. value for expected and actual changes in the price of the underlying
asset.

Mortgage Payable
This account records long-term debt of the business entity for
which the business entity has pledged certain assets as a security to Examples of Derivatives
the creditor.
Futures Contracts
A futures contract is an agreement between a seller and a
EQUITY INSTRUMENTS buyer that requires that seller to deliver a particular commodity (say
corn, gold, or beans) at a designated future date, at a predetermined
An equity instrument is any contract that evidences a residual
price. These contracts are actively treated on regulated future
interest in the assets of an entity after deducting all of its liabilities.
exchanges and are generally referred to as “commodity futures
Examples of Equity Instruments are: contract”. When the “commodity” is a financial instrument such as
Treasury bill or commercial paper, the agreement is referred to as a
 Ordinary shares
financial futures contract. Futures contract are purchased either as an
 Preference shares investment or as a hedge against the risks of future price changes.
 Warrants or written call option that allow the holder to
subscribe or purchase ordinary shares in exchange for a fixed
amount of each or another financial asset. Forward contracts
A forward contact is similar to a futures contract but differs in three
DERIVATIVE FINANCIAL INSTRUMENTS ways:

Derivatives are financial instruments that “ derive” their value 1. A forward contract calls for a delivery on a specific date,
on contractually required cash flows from some other security or whereas a futures contact permits the seller to decide later
index. For instance, a contract allowing a company to purchase a which specific day within the specified month will be the
particular asset (say gold, flour, or coffee bean) at a designated future delivery date.
 2. Unlike a futures contact, a forward is usually not traded on a There are contracts to exchange cash flows as of a specified
market exchange. date or a series of specified dates based on a notional amount and
3. Unlike a futures contract, a forward contract does not call for fixed and floating rates.
a daily cash settlement for price changes in the underlying
INTEREST RATES
contract. Gains and losses on forward contacts are paid only
when they are closed out. One of the most important factors affecting the transfer of
funds from savers to borrowers is interest rate. The interest rate is the
price paid for the use of money, and it is determined by the
Options combination of producers’ expected rates of return on invested capital
and consumers’ time preferences for consumption. Many factors go
Options give its holder the right either to buy or sell an
into making up the actual interest rate. It is composed of the real and
instrument, say a Treasury bill, at a specified price and within a given
risk free rate, plus premium to compensate investors for expected
time period. Options frequently are purchased to hedge exposure to
inflation, default risk, lack of liquidity risk and maturity risk.
the effects of changing interest rates. Option serves the same
purpose as futures in that respect but is fundamentally different.
How Interest Rates are Determined
Foreign Currency Futures Interest rates are determined by the demand for and supply of
loanable funds. Investors demand funds in order to finance capital
Foreign loans frequently are denominated in the currency of
assets that they believe will increase output and generate profit.
the lender (Japanese yen, Swiss franc, German mark, and so on).
Simultaneously, consumers demand loanable funds because they
When loans must be repaid in foreign currencies, a new element of
have a positive rate of time preference. They prefer earlier availability.
risk is introduced. This is because if exchange rates change, the peso
equivalent of the foreign currency that must be repaid differs from the
peso equivalent of the foreign currency borrowed.
Interest Rates and Risks

Interest rates in the loanable funds market will differ mainly

Interest Rate Swaps because of differences in the risks associated with the loans. It is
riskier, for example, to loan money to an unemployed worker than to a
well-established business with substantial assets. Similarly, credit
card loans are riskier than loans secured by an asset. An example of
a secured loan will be a mortgage loan on a house. If the borrower
defaults, the render can repossess the house. The risk also increases
with the duration of the loan. The longer the time period of the loan,
the more likely it is the borrower’s ability to repay the loan will
deteriorate or market conditions changes in highly unfavourable
manner.
TABLE: The Three Components of Money Interest
Risk premium
TAXES
The value of any financial asset, including corporate equity
shares, bonds, notes and mortgage as well as the values of most real
assets such as plants and even the entire firm, depends on the
stream of cash flows after taxes produced by the asset. The types of
taxes affecting business are now taxes on income, employment,
transaction, property, environmental and excise, to name the major
categories. Managers in any business must know the impact of taxes
on their operation. As we write this, the current Philippines
administration and congress are debating the merits of different
proposed reforms in the tax laws.

Inflationary premium

Pure interest

Effects of Change in Interest Rates

Control over short-term interest rates in one of the main tools

of the Bangko Sentral ng Pilipinas (BSP) to achieve its main goals of
controlling inflation, smoothing out the business cycle and ensuring
financial stability.

Short-term interest rates are relevant for loans with a

relatively short length for repayment while long-term interest rates on
the other hand, are relevant for loans such as long-term corporate
borrowing and 10-20-30 year fixed rate mortgages.