Topic

Financial Instruments – Part C

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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 9)

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 are 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 other party accepts the
risks associated with changing commodity prices or exchange rates

Three principal types of hedges (AASB 9)

1. Fair value hedges
2. Cash flow hedges
3. Hedges of net investments in foreign operations (we will not be
considering these)

Need to differentiate between hedged item and hedging instrument

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 Derivatives used within a hedging
arrangement

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 requirements are satisfied in terms of the hedging

arrangement (AASB 9):
• 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
Fair value hedge
• Both the hedged item and the hedging instrument are to be measured at
fair value
• Any gains or losses to be included as part of profit or loss

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’)
• When the underlying asset is acquired, or the liability settled, the gain or
loss on the hedging instrument is adjusted against the cost of the asset, or
liability
• Thereafter, any gains or losses on the hedging instrument are transferred
to profit or loss to offset gains or losses on hedged item
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 Illustration 5—Cash flow hedge of a highly
probable forecast transaction

Oz Ltd manufactures electric cars

On 15 June 2022, 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 2022
The total contract price was US$2 000 000 and the full amount was due for
payment on 30 August 2022
Because of concerns about movements in foreign exchange rates, on 15
June 2022 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 2022
at a forward rate of $A1.00 = US$0.80 (meaning A$2 500 000 will be
payable to the foreign currency broker)
Oz Ltd elects to treat the hedge as a cash flow hedge

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Deegan 2020, p568 Worked Example 14.18
 Illustration 5—Cash flow hedge of a highly
probable forecast transaction

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 2022, are also provided.
On 30 August 2022, 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 2022 $A1.00 = US$0.83 $A1.00 = US$0.80
30 June 2022 $A1.00 = US$0.81 $A1.00 = US$0.78
30 Aug. 2022 $A1.00 = US$0.76 $A1.00 = US$0.76
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 Illustration 5—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 (the accounts payable) are calculated as
follows:
Amount payable Foreign exchange
Date Spot rate in $A gain/(loss)
15 June 2022 $A1.00 = US$0.83 –
30 June 2022 $A1.00 = US$0.81 $2 469 136
30 Aug. 2022 $A1.00 = US$0.76 $2 631 579 (162 443)

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 Illustration 5—Solution

Gains/losses on the hedging instrument (the forward rate contract on US dollars with a
foreign exchange broker so as to receive US$2 000 000 on 30 August 2022 ) are calculated
as follows:

Date Fwd rate for Receivable in $A Amount payable Fair value Gain/(loss) on
delivery of US$ on fwd contract in A$ on forward of forward forward
on 30 Aug 2022 contract contract contract
15/6/2022 $A1.00 = US$0.80 $2 500 000 $2 500 000 0
30/6/2022 $A1.00 = US$0.78 $2 564 103 $2 500 000 $64 103 $64 103
30/8/2022 $A1.00 = US$0.76 $2 631 579 $2 500 000 $131 579 $67 476
$131 579

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 Illustration 5—Solution

30 June 2022
Dr Forward rate contract (financial asset) 64 103
Cr Cash flow hedge reserve (OCI) 64 103
(to recognise the fair value of the forward rate contract)
Dr Inventory 2 469 136
Cr Foreign currency payable 2 469 136
(to recognise the purchase of inventory at a spot rate of $A1.00 = US$0.81)
Dr Cash flow hedge reserve (OCI) 64 103
Cr Inventory 64 103
(to transfer the gain/loss on the hedging instrument [forward rate contract] to
inventory)
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
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 Illustration 5—Solution

30 August 2022
Dr Forward rate contract (financial asset) 64 476
Cr Gain on forward rate contract 64 476
(to recognise the gain on the forward rate contract)
Dr Foreign exchange loss 162 443
Cr Foreign currency payable 162 443
(to recognise the loss on the foreign currency payable)
Dr Cash at bank 131 579
Cr Forward rate contract 131 579
(to recognise the receipt of the amount receivable in relation to the
forward rate contract)
Dr Foreign currency payable 2 631 579
Cr Cash at bank 2 631 579
(amount paid to overseas battery supplier)
As we can see from the above two entries, the net amount paid for the
11 batteries was $2 500 000 (which is $2 631 579 – $131 579), which equates
to the amount negotiated in the forward rate contract
 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
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
Significant losses (or gains) can be made on the futures market

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 Futures contracts

Share price index (SPI) futures

• Based on, for example, 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 Deegan 2020 p574 Worked Example 14.21—Use of share price

index futures

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 Journal entries for SPI futures (assuming
share market is ‘falling’)

To make a percentage deposit with a futures broker

Dr Deposit on SPI futures x
Cr Cash at bank x

To ‘mark to market’ the value of the organisation’s share portfolio

Dr Loss on share portfolio x
Cr Share portfolio x

To credit gains to the initial deposit held by the futures broker

Dr Deposit held by broker x
Cr Gain on futures contract x

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 Journal entries for SPI futures (cont.)

If shares are sold and futures contract is closed out:

Dr Cash x
Dr Loss on share portfolio x
Cr Share portfolio x

Dr Deposit held by broker x

Cr Gain on futures contract x

Dr Cash at bank x
Cr Deposit held by broker x

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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

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

To record investment in share options

Dr Investment in share options x
Cr Cash at bank x

To value share options at fair value

Dr Investment in share options x
Cr Profit on share options x

Refer to Deegan 2020 p579 Worked Example 14.23—Valuation of options

at net market price

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 Compound instruments

Contain both a financial liability and an equity component

Include convertible bonds
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

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 Illustration 6—Accounting for compound
instruments
Grommett Ltd issues $10 million of convertible bonds on 1 July 2022. The
bonds have a life of four years and a face value of $10.00 each, and they
offer interest, payable at the end of each financial year, at a rate of 6 per
cent per annum. The bonds are issued at their face value and each bond
can be converted into one ordinary share in Grommett Ltd at any time in
the next four years. Organisations of a similar risk profile have recently
issued debt with similar terms, without the option for conversion, at a rate
of 8 per cent per annum.
REQUIRED
a) Identify the present value of the bonds and, allocating the difference
between the present value and the issue price to the equity
component, provide the appropriate accounting entries.
b) Calculate the stream of interest expenses across the four years of the
life of the bonds.
c) Provide the accounting entries if the holders of the options elect to
convert the options to ordinary shares at the end of the third year of
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the bonds. Deegan 2020, p586 Worked Example 14.26
 Illustration 6—Solution

We can identify the present value of the bonds and then allocate to the equity
component the difference between the present value of these bonds and the issue
price of $10 million. In determining the present value, we will use the rate of 8 per
cent, which is the rate of interest paid on debt of a similar nature and risk that does
not provide an option to convert the liability to ordinary shares.

Present value of bonds at the market rate of debt

Present value of principal to be received in 4 years discounted at 8 per cent
$10 000 000 × 0.735 03 = $7 350 300
Present value of interest stream discounted at 8 per cent
$600 000 × 3.312 113 = $1 987 268
Total present value $9 337 568
Equity component $662 432
Total face value of convertible bonds $10 000 000

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 Illustration 6—Solution

1 July 2022
Dr Cash at bank 10 000 000
Cr Convertible bonds (liability) 9 337 568
Cr Convertible bonds (equity component) 662 432
(to record the issue of the convertible bonds and the recognition of the liability and equity
components—the equity component in this case would be $662 432)

30 June 2023
Dr Interest expense 747 005
Cr Cash 600 000
Cr Convertible bonds (liability) 147 005
(to recognise the interest expense, where the expense equals the present value of the opening
liability multiplied by the market rate of interest; see table that follows)

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 Illustration 6—Solution

Date Payment Interest Increase in Bond liability

6% x bond expense 8% x bond liability
face value bond liability
1 July 2022 9 337 568
30 June 2023 600 000 747 005 147 005 9 484 573
30 June 2024 600 000 758 766 158 766 9 643 339

30 June 2025 600 000 771 467 171 467 9 814 806

30 June 2026 600 000 785 194 185 194 10 000 000

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 Illustration 6—Solution

If the holders elect to convert the options to ordinary shares at the end of the
third year of the debentures (after receiving their interest payments), the
entries in the third year would be:

30 June 2025
Dr Interest expense 771 467
Cr Cash 600 000
Cr Convertible bonds (liability) 171 467
(to recognise interest expense for the period)

Dr Convertible bonds liability 9 814 806

Dr Convertible bonds (equity component) 662 432
Cr Share capital 10 477 238
(to recognise the conversion of the bonds into shares of Grommett Ltd)

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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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 Disclosure requirements

Various disclosures related to the ‘risks’ associated with financial

instruments (AASB 7.32–42)
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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