ACCT3321 Lecture Notes - Lecture 6: Embedded Option, P16, Metar
CHAPTER 11
Financial Instruments
- A financial instrument:
oAny contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity
-Transactions that result in financial instruments
oFinancial instruments ultimately lead to the receipt or payment of cash or
issue of equity instrument between parties
oPrimary instruments – cash, receivables, investments and payables
oDerivative instruments – financial options, futures and forward exchange
contracts
They derive their value from an underlying item, such as a share price
index or interest rates
oMay relate to singular instruments – such as a loan receivable, loan payable
or ordinary share issued
oMay include compound instruments
oThe obligation to make payments of interest and principal on the convertible
notes is a financial liability
oThe conversion option that may require the company to issue shares in an
equity instrument
-Transactions that do not result in financial instruments
oPurchase or lease of non-financial asset
oContracts that involve the prepayment of cash for goods or services
oCommodity contracts that are settled by the delivery of non-financial assets
oRights or obligations that result from statutory requirements imposed by
governments such as tax liabilities
oEnvironmental obligations imposed by governments on mining companies to
restore or rehabilitate land after mining activities have ceased
oMost warranty obligations of manufacturers
FINANCIAL ASSETS
-any asset that is:
.(a) cash;
.(b) an equity instrument of another entity;
.(c) a contractual right: (i) to receive cash or another financial asset from another entity; or(ii)
to exchange financial assets or financial liabilities with another entity under conditions that
are potentially favourable to the entity; or
.(d) a contract that will or may be settled in the entity’s own equity instruments and is: (i) a
non-derivative for which the entity is or may be obliged to receive a variable number of the
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entity’s own equity instruments; or (ii) 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.
- examples: bank deposit, investment in shares, trade or loan receivables, purchase
options and other derivatives such as forward or future contracts
- certain contracts settled in the entity’s own equity instruments are excluded from
the part (d)(ii) definition because the contracts do not carry financial risk.
- The exclusions relate to:
oPuttable financial instruments classified as equity instruments
oInstruments that impose on the entity an obligation to deliver to another
party a pro rata share of the net asset of the entity only on liquidation
oInstruments that are contracts for the future receipt or delivery of the
entity’s own equity instruments
oThese only carry equity risk – the risk of changes in value of the equitable or
residual interest in net assets – rather equity instruments rather than
financial instruments
FINANCIAL LIABILITIES
any liability that is:
(a) contractual obligation:
1(i) to deliver cash or another financial asset to another entity; or
2(ii) to exchange financial assets or financial liabilities with another entity
under conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to deliver a
variable number of the entity’s own equity instruments; or
(ii) 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. For this purpose, rights, options or warrants
to acquire a fixed number of the entity’s own equity instruments for a fixed
amount of any currency are equity instruments if the entity offers the rights,
options or warrants pro rata to all of its existing owners of the same class of its
own non-derivative equity instruments.
- examples: bank overdrafts, trade or loan payable, debentures issued, convertible
notes issued, sold options and other derivatives such as forward or futures contracts
- the entity’s own equity instruments that are excluded from part (d)(ii) of the
financial asset definition are also excluded from part (b)(ii) of the definition of
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financial liability
- the excluded contracts give rise to equity instruments rather than financial liabilities
- if the contract includes an unconditional right to avoid delivering cash or another
financial asset, the financial instrument is classified as equity by the issuer
DERIVATIVE INSTRUMENTS
(a) its value changes in response to the change in [the ‘underlying’, which may be] a
speci ed interest rate, nancial instrument price, commodity price, foreign exchange
rate, index of prices or rates, credit rating or credit index, or other variable, provided
in the case of a non- nancial variable that the variable is not speci c to a party to the
contract . . .
(b) it requires no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a
similar response to changes in market factors.
(c) it is settled at a future date.
- fundamentally, all derivatives derive their value from an underlying item such as a
share price
- involve contractual rights and obligations that have the effect of transferring
between the parties to the instrument one or more of the financial risks inherent
- usually favourable for one party and unfavourable for the other
- examples: futures and forward contracts, swaps and option contracts
- example p 7
-Hybrid contracts with embedded derivatives
oA component of a hybrid contract that also includes a non-derivative host –
with the effect that some of the cash flows of the combined instrument vary
in a way similar to a stand-alone derivative.
oCannot be contractually detached from the host contract, or have a different
counterparty
oThree conditions that specifies that an embedded derivative can be
accounted for separately from the host
(a) the economic characteristics and risks of the embedded derivative
are not closely related to the economic characteristics and risks of the
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Document Summary
A financial instrument: any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Financial liabilities any liability that is: (a) contractual obligation: 1 (i) to deliver cash or another financial asset to another entity; or. Equity conversion feature embedded in a host convertible debt instrument. Option to extend the remaining term to maturity of a debt instrument without a concurrent adjustment to the market rate of interest at the time of the extension. Any contract that evidences a residual interest in the asset of an entity after deducting all its liabilities. Ordinary shares are the most common type shareholders are not entitled to a fixed return on their investment but hold an equitable interest. A company will prefer an equity classification because instruments in liabilities may have adverse financial effects. Periodic payments are treated as borrowing costs instead of dividends reducing reported profit.
