BE130 – Lecture 4 - Financial Instruments PDF

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BE130 – Current IssuesLecture 4 – Financial InstrumentsFinancial Reporting: Background  Equity valuations  need accounting info especially concerning changes in cash flows  Accounting entries (book entries) vs. cash flows (changes in cash in/cash out)  Financial instruments = derivativesAccounti...

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BE130 – Current Issues Lecture 4 – Financial Instruments Financial Reporting: Background  Equity valuations  need accounting info especially concerning changes in cash flows  Accounting entries (book entries) vs. cash flows (changes in cash in/cash out)  Financial instruments = derivatives Accounting Policies  Accounting regulators (IASB)  IAS/IFRSs  Policies can be highly subjective  Affect Accounting, reported earnings and hence capital markets IAS 39  Financial Instruments: Recognition and Measurement IFRS 9  Financial Instruments: IFRS 7  Disclosures IFRS 9 primarily concerned with classifying AND measuring financial assets. During 2010 the IASB will expand IFRS 9 to include de-recognition, impairments and hedge accounting. Types of Measurement IFRS 9 divides al financial assets included in the scope of IAS 39 into into 2 key categories: 1. Amortised Cost 2. Fair Value (FV) Financial assets are classified on initial recognition. Categories of Classification 1. Financial assets at fair value through profit or loss (FVTPL) 2. Held to maturity investments (HTM) [Currently in IAS 39] 3. Loans and receivables (L&R) 4. Available-for-sale financial assets (AFS) Examples IAS 39 Financial Instruments  Recognition and Measurement requires the classification of financial instruments into separate categories:  FVTPL  Derivatives, comprising foreign exchange contracts, interest rate swaps and commodity swaps, are classified as held for trading  L and R  Fixed deposits, principally comprising funds held with banks and other financial institutions, and trade receivables are classified as loans and receivables  Available-for-sale  Investments (other than fixed deposits and interests in joint ventures and associates) and short-term deposits (other than fixed)

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Other liabilities: Borrowings, trade payables, financial RRSPs and C S hares are classified as other liabilities

Debt Instruments A debt instrument that meets the following two conditions can be measured at amortised cost: 1. Business model test  if the entity’s business model is to hold the financial asset to collect the contractual cash flows 2. Cash flow characteristic test  the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the o/s principal All other debt instruments must be measured at fair value through profit or loss (FVTPL). Category 1 - FVTPL  Assets that the entity either:  Holds for trading purposes  Has elected to classify as such. Purpose: buying and selling  Derivative assets – treat as ‘held for trading’ (unless for hedging)  Impairment  fair value in balance sheet, changes in FV to income statement Category 2 - HTM  Not selling until maturity  Not including shares – equity based products – no maturity date  Must be quoted in active market  Held at amortised cost – any p/l taken being recognised over life  Balance sheet show as amortised cost  P/I  recognise realised gamins/losses Category 3 - Loans and Receivables  Loans and receivables – including financial assets with fixed or determinable payments – that are not quoted in ACTIVE market  Show in balance sheet as amortised cost  P/L realised gains/losses plus impmts Category 4 - Available for Sale  Available for sale financial assets  Any other asset not falling into above  Reported at fair value in balance sheet  In P/L a/c include realised gains and losses Two categories of Fin Libs 1. Fin libs at FV through p/l a/c 2. Fin libs at amortised cost Reclassifications  Severely restricted in IAS39

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 Difficult but not always impossible IASB now allows banks trading assets to be reclassified into categories if: A. Available for sale or repurchase B. Held to maturity C. No impact in earnings Amortised cost  Calculated using ‘effective interest rate’ (EI)  EI  the RATE that discounts exactly future cash payments/receipts over expected life of financial instrument to the NET CARRYING amount of the financial asset/liability Financial assets and liabilities measured at amortised cost if:  HMT investments  L and Rs  Financial liabilities not measured at FV through p/l a/c Financial assets and financial liabilities measured at FV if:  FVTPL  AFS  Financial liabilities at FVTPL Issues Basis of Reporting:  Historic values  Increasingly regarded as out-moded and frequently irrelevant in producing meaningful financial statements  Current values  Fair Value Accounting (FVA) Fair Value “The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm's length transaction” FVA   

Market assets to market values ‘Mark to Myth’ or ‘Mark to Make Up’ US accounting rules also require companies to mark assets to market (fair) values  as a result, AIG has already written down $11bn off mortgage related assets Objective of FVA AIG claims that the ‘mark to market’ method compels companies to write down assets – even when the companies have no intention of selling the assets in their currently depressed state. Extent  The credit crunch could cost the world's banking system the best part of $1tn (£500bn), the [International Monetary Fund, April 2008.]

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The IMF's half-yearly Global Financial Stability Report (2008): "The events of the past six months have demonstrated the fragility of the global financial system and raised fundamental questions about the effectiveness of the response by private and public sector institutions.

Mark to Model  develop apply quant. Models Reporting ‘As It Is’  IASB strongly supports FVA.  Claimed: “accounting standards are based on the economic reality that exists currently – not on management’s optimistic view of what will occur in the future.”  David Tweedie, chairman of the IASB claims that accounting should report economic reality ‘as it is’ - rather than pandering to vested interest groups. Impairment of Assets Quite simply, if an asset has a nil or low fair value at the end of a reporting period then any asset impairment must be written off. To suggest otherwise, that at a future unspecified date, the assets might, one day, just be priced higher is a weak basis for any accounting model. Impairments FAS 157 and FAS 159 required banking and financial institutions to identify more clearly and determine the fair value of their financial assets and instruments. By themselves, these two standards should be welcomed since investors can more clearly assess the extent of banks’ liabilities. But in practice, these two standards will require banks to write-off even larger volumes of their debts and sub-prime loans. IAS 36 Impairment of Assets  Based on recoverable amount (RA):  RA = higher of net realisable value (i.e. fair value) and Value in Use (Discounted cash flows).  Carrying Amount  If CA > RA then Impairment From November 2007, FAS 157 will require banks to classify and value their assets into three main categories:  Tier 1 assets  ‘mark to market’ values and usually consist of readily marketable assets. [These types of assets are the least contentious to value and include listed equities, government securities and gold bullion.]  Tier 2 assets more specialised and often their value is more opaque, especially where quoted market values are frequently restricted for many types of assets. [Even so, these assets will still have a high degree of ‘tradeability’ and there will normally be sufficient ‘observable’ financial inputs to determine a market value.]  Tier 3 category  these assets include complex derivatives, collaterised debt obligations and many of the ‘sliced and diced’ sub prime mortgage debt. In

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the present turbulent credit markets, it is not generally possible to obtain a fair market value for these types of assets in stagnant and non-active markets. The new accounting regulations will require banks to value these Tier 3 assets using the best information available – but without incurring undue cost or effort  It is this asset category that will pose the most severe problems for some banking groups. Many of the assets such as CDOs and Structured Investment Vehicles may have to be valued by esoteric and complex mathematical models. But in the current turbulence of credit markets many values of financial instruments are largely frozen leading to a theoretical value based on largely guessing the mathematical numbers for inputting into valuation models. Hedging Instruments  Hedging item exposes the entity to risk of changes in fair value or future cash flows and is designated as being hedged Two main categories of Hedges: 1. FV Hedge  where gain or loss from changes in FV of hedging instmt recognised immediately in p/l 2. Cash flow hedge where exposure to variability of CFs  Gain/loss on hedging to other Comp Income CDOs  Collateralized Debt Obligations  type of asset-backed security and structured credit product  ‘Structured finance’  general term by which financial instruments can be used to help transfer risk - using complex legal and corporate entities. SIV  Structured Investment Vehicle  a fund which borrows other funds by issuing short-term securities at low interest and then lends those funds by purchasing longterm securities at higher interest, - and making a profit for investors from the difference. Off Balance Sheet Finance (OBSF)  The global ‘credit crisis’ shown just how many companies are still spreading the OBSF disease.  US: Robert Herz, FASB chairman is gathering evidence about just how many of the leading banks have found legal and accounting ways around the strenuous anti-OBSF measures - implemented in the wake of Enron....