Financial Accounting & Reporting (FIN)

Financial instruments

Virtual Classroom 2

Slide 1
 FIN VC Session 2

Scenario

Slide 2
 FIN VC Session 2

Scenario – Part A
NITS needs to raise the finance to fund the acquisition from Ballot and has We’ll look at
Option 2 soon
identified two different financing options.
Option 1
Raise $7,000,000 from the issue of 700,000 preference shares on
30 November 20X3. This will enable sufficient funds to be raised to finance
the €5,000,000 payable to Ballot under the contract.
Details of the issue are:
• Issue costs of $700,000.
• 6% fixed dividend per annum subject to NITS having sufficient liquidity to
declare and pay the dividend.
• Redeemable in cash at the option of NITS at any time until 31 December
20X8. Otherwise they mandatorily convert to 700,000 ordinary shares.
Slide 3
 FIN VC Session 2

Financial instruments
Required

a) Determine  how the preference shares will be classified under IAS

32 Financial Instruments: Presentation. You should refer to relevant
paragraphs of this Accounting Standard to support your answer.

Slide 4
 FIN VC Session 2

Classify the preference shares under IAS 32

Financial
instrument

Financial Financial Equity

asset liability instrument

Defined in Defined in
IAS 32 para. 11 IAS 32 para. 11
‘contractual obligation’
Slide 5
 FIN VC Session 2

Classify preference shares under IAS 32

Convert with fixed
Contractual
Terms or variable number
obligation?
of shares?

6% fixed dividend per annum N/A

Redeemable in cash at the option
of NITS at any time until 31/12/X8 N/A

Otherwise mandatorily convert

to 700,000 ordinary shares N/A FIXED

IAS 32 para.
Equity 16(a) & (b) met?

Slide 6
 FIN VC Session 2

Solution – Part A – Task (a)

Item Classification Reference to Accounting Standard
Preference Equity A fixed dividend rate does not indicate a contractual obligation. This
shares depends on the terms relating to when the fixed rate dividend must be
paid; that is, whether it is discretionary. As the dividend is paid subject to
NITS having sufficient liquidity to declare and pay the dividend, this
indicates that the payment is not a contractual obligation. An ‘economic
compulsion’ to pay a dividend does not amount to a contractual obligation.

Therefore, if the payment of the dividend itself is discretionary, it does not

matter if the amount to be paid is fixed (IAS 32 para. 17).

Because the instrument is repayable only at NITS’ discretion, there is no

contractual obligation to repay the initial investment (IAS 32 para. 16(a))

Where a non-derivative instrument converts into a fixed number of shares,

IAS 32 indicates that the instrument is equity (IAS 32 para. 16(b))

As the equity classification requires IAS 32 paras 16(a) and 16(b) to be

satisfied, the preference shares are equity as both sub-paragraphs are
met

Slide 7
 FIN VC Session 2

Financial instruments
Required

a) Explain how each of the financing options will be accounted for, ignoring
any possible implications of IAS 23 Borrowing Costs. You are not required
to perform any calculations or prepare journal entries.

Slide 8
 FIN VC Session 2

Accounting treatment of preference shares

classified as equity
Initial Redemption or
recognition conversion

Preference shares on issue

Fair value less

Directly in equity
transaction costs

Not remeasured

Dividends – directly in
equity

Slide 9
 FIN VC Session 2

Scenario – Part A
Option 2
Obtain a €5,500,000 loan from Argent Bank in France.
The loan has the following features:
• Loan term – 30 November 20X3 to 30 November 20X8.
• No principal repayments are due over the life of the loan – as such, the full amount of
€5,500,000 will be repaid on 30 November 20X8.
• Transaction costs directly attributable to the loan – €500,000.
• Interest rate – 2.8% per annum, paid annually in arrears. The annual effective interest
rate on the loan is 4.8936%.
Additional information:
• The loan will be acquired to finance the equipment purchase. NITS intends to make
the interest payments as required and then repay the loan at maturity on 30 Nov 20X8
• There is no measurement mismatch regarding the loan & the loan is not managed as
part of a portfolio managed for short-term profit taking
• There is no documented group of financial liabilities managed as part of any risk
management or investment strategy.
Slide 10
 FIN VC Session 2

Accounting treatment of a financial liability

NITS
NITS borrowing
borrowing from
fromArgent
Argent Bank
Bank
IFRS 9 classification

FVTPL
FVTPL Amortised
Amortised cost
cost

Initially
Initially
Held
Heldfor
fortrading?
trading? designated?
designated?

Slide 11
 FIN VC Session 2

Accounting treatment of a financial liability

NITS
NITS borrowing
borrowing from
fromArgent
Argent Bank
Bank
IFRS 9 classification

FVTPL
FVTPL Amortised
Amortised cost
cost

Initially
Initially
Held
Heldfor
fortrading?
trading? designated?
designated?
Was it acquired for Measurement
selling in the near term? mismatch?
Is it part of portfolio with Portfolio: performance
a recent pattern of short evaluated on FV basis?
term profit-making?
Is it a derivative?

Slide 12
 FIN VC Session 2

Accounting treatment of borrowing

at amortised cost
Initial
recognition Repayment

Fair value Borrowing outstanding

less
transaction
costs Amortised cost

Amount at initial Accrued Closing

recognition  Repayments  interest  liability

Spot
Spotrate
rate Spot
Spotrate
rate Average
Averagerate
rate Closing
Closingrate
rate

Any exchange differences recognised in profit or loss

Slide 13
Financial Accounting & Reporting (FIN)

Hedge accounting

Virtual Classroom 2

Slide 14
 FIN VC Session 2

Scenario – Part B
NITS has an interest-only borrowing of €5,500,000 from Argent Bank in
France. The loan principal is repayable on 30 November 20X8 and was
classified at amortised cost under IFRS 9.
NITS management is concerned about the weakening of the Australian
dollar against the euro and the uncertainty this will bring to the value/
repayment of the loan principal of €5,500,000 at 30 November 20X8.
As a result, on 1 July 20X8, NITS entered into a forward contract to buy
€5,500,000 at 30 November 20X8 for $7,638,889.
The forward contract will be settled net in cash.
NITS’ functional currency is the Australian dollar and it has a
30 June year end.

Slide 15
 FIN VC Session 2

Scenario – Part B

Ballot €500,000
transaction costs
SARL
€5,500,000 loan
ARGENT
€5,000,000 for 30 Nov 20X3 BANK
equipment

BANK

Slide 16
 FIN VC Session 2

Scenario – Part B

Ballot
SARL
€5,500,000 loan
repayment ARGENT
30 Nov 20X8 BANK

€5,500,000 $7,638,889

Forward 1 July 20X8

contract

BANK

Slide 17
 FIN VC Session 2

Required – Part B – Task (a) (i)

a) Assuming that the criteria for hedge accounting are met,
explain whether the designated hedge relationship can be
classified under IFRS 9 as a fair value hedge and/or a cash
flow hedge, in respect of the:
i. NITS forward contract.

Slide 18
 FIN VC Session 2

Review the Standard for guidance

on hedge relationships

Reference
IFRS 9
para 6.4.1 and 6.5.2

Slide 19
 FIN VC Session 2

Types of hedge relationships

Hedging
relationship

Fair value Cash flow Net

hedge hedge investment
hedge

IFRS 9 para IFRS 9 para 6.5.2 (b)

6.5.2(a)

Slide 20
 FIN VC Session 2

Identify the hedge relationship

Hedged Hedging Hedged

item instrument risk
Recognised Forward Movement in
liability contract recognised
liability due to
exchange rate
fluctuations

Fair value hedge

Slide 21
 FIN VC Session 2

Identify the hedge relationship

Hedged Hedging Hedged

item instrument risk
Future cash Forward Variability of
flows on contract future cash
repayment of flows due to
the loan exchange rate
fluctuations

Cash flow hedge

Slide 22
 FIN VC Session 2

Scenario – Part B continued

NITS has been negotiating with a transport company in Ireland,
Travel With Us Limited (TWU), to license their timetabling software
for a period of five years, commencing 1 August 20X9 for A$500,000.
The contract is nearing finalisation but has not yet been signed.
On 1 May 20X9 TWU entered into a forward contract to buy
A$500,000 on 1 August 20X9 for €297,265 (based on a forward rate
of €1: A$1.682) in anticipation of signing the licensing agreement.
The forward contract will be settled net in cash.

Slide 23
 FIN VC Session 2

Scenario – Part B
$500,000 for
software license

1 Aug 20X9

€297,265

1 May 20X9 Forward

contract
$500,000

BANK

Slide 24
 FIN VC Session 2

Required – Part B – Task a) (ii)

a) Assuming that the criteria for hedge accounting are met, explain
whether the designated hedge relationship would be classified
under IFRS 9 as a fair value hedge and/or a cash flow hedge, in
respect of the:
ii. TWU forward contract.

Slide 25
 FIN VC Session 2

Identify the hedge relationship

Hedged Hedging Hedged

item instrument risk
Future cash Forward Variability of
flows relating to contract future cash
the highly flows due to
probable exchange rate
forecast fluctuations
transaction

Cash flow hedge

Slide 26
 FIN VC Session 2

Scenario – Part B continued

The fair value of the forward contract entered into by TWU
has been measured at the relevant dates as follows:
Date Fair value of the TWU forward contract asset
€
01.05.X9 0
30.06.X9 22,500
01.08.X9 38,080

Slide 27
 FIN VC Session 2

Scenario – Part B
The change in the present value of the future outflow relating
to the licence purchase is shown below:
Date Incremental change in present value of future cash
outflow of A$500,000
€
01.05.X9 n/a
30.06.X9 (24,578)
01.08.X9 (13,502)

The spot exchange rate at 1 August 20X9 is

€1: A$1.491.

TWU has a functional currency of the euro and a 30 June

year-end. Ignore the tax effect implications.
Slide 28
 FIN VC Session 2

Required – Part B – Task (b)

b) Prepare the journal entries to record TWU’s forward contract
on initial recognition and at 30 June 20X9.

Assume that it is designated as a cash flow hedge and that all

relevant hedge documentation is in place. TWU has
determined there is an economic relationship between the
hedged item and the hedging instrument, and is satisfied this
relationship still exists at balance date. There is little credit risk
in the relationship and the hedge ratio is within TWU’s
documented policy.

Slide 29
 FIN VC Session 2

Review the Standard

for guidance on hedge relationships

References
IFRS 9 para 6.5.11 for cash
flow hedges. Once 6.4.1 is
satisfied

Slide 30
FIN VC Session 2

Slide 31
 FIN VC Session 2

Amount recognised in the cash flow hedge

reserve (CFHR) at 30 June
Lower
Lower of
of
(in
(in absolute
absolute terms)
terms)

Cumulative
Cumulativegain
gain Cumulative
Cumulative
or
orloss
losson
onthe
the change
changeininthe
the
hedging
hedging fair
fairvalue
valueof
ofthe
the
instrument
instrument hedged
hedgeditem
item

€22,500
€22,500 €24,578
€24,578

Slide 32
 FIN VC Session 2

Journal entry – amount recognised in the CFHR

Lower
Lower of
of
(in
(in absolute
absolute terms)
terms)
Date Account description Dr € Cr €
Cumulative
Cumulativegain
gain 30.06.X9 Forward contract 22,500
or
orloss
losson
onthe
the Cash flow hedge reserve 22,500
hedging
hedging To record the gain on the forward contract recognised in
instrument
instrument the CFHR

€22,500
€22,500

Slide 33
Thank you

Slide 34