Textbook Notes (368,122)
Canada (161,660)
MGAC02H3 (21)
Daga (10)
Chapter 16

Chapter 16 Notes

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Department
Financial Accounting
Course
MGAC02H3
Professor
Daga
Semester
Fall

Description
Chapter 16 Complex Financial Instruments Notes Exclude p 10311038 accounting portion of hedging Appendix B Derivatives y financial instruments are contracts that create a financial asset for one party and a financial liability or equity instrument for the other y primary financial instruments include most basic financial assets and financial liabilities as well as equity instruments y derivative instruments are called as such because they derive their value from an underlying primary instrument index or nonfinancial item such as a commodity y derivatives are defined by the accounting standards as financial instruments that create rights and obligations that have the effect of transferring between parties to the instrument one or more of the financial risks that are inherent in an underlying primary instrument without either party having to hold any investment in the underlying y they have three characteristics 1 their value changes in response to the underlying instrument 2 they require little or no initial investment and 3 they are settled at a future date y options forwards and futures are common types of derivatives Understanding Derivatives Managing Risks y there are many layers of costs relating to the use of derivatives y three categories of costs are as follows 1 direct costs 2 indirect costs and 3 hidden or opportunity costs y companies use derivatives to manage risks and especially financial risks y there are various kinds of financial risks and they are defined in IFRS as follows 1 Credit riskThe risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge respect an obligation 2 Liquidity riskThe risk that an entity will have difficulty meeting obligations that are associated with financial liabilities 3 Market riskThe risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices There are three types of market risk currency risk interest rate risk and other price risk a Currency riskThe risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates b Interest rate riskThe risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates c Other price riskThe risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices other than price changes arising from interest rate risk or currency risk whether those changes are caused by factors that are specific to the individual financial instrument or its issuer or factors that affect all similar financial instruments being traded in the market Recognition and Measurement of Derivatives y the basic principles regarding accounting for derivatives are as follows 1 Financial instruments including financial derivatives and certain nonfinancial derivatives represent rights or obligations that meet the definitions of assets or liabilities and should be recognized in financial statements when the entity becomes party to the contract 2 Fair value is the most relevant measure 3 Gains and losses should be booked through net income NonFinancial Derivatives and Executory Contracts y purchase commitments are generally labelled as executory contracts contracts to do something in the future where no cash or product changes hands up frontPurchase commitments for nonfinancial Forwardsfuturesoptions to buysell nonassets eg inventory financial assets eg inventory Legal form Purchase contractcommitment Generally Forwardfutures option contract does not include net settlement clause Trade on a market thus establishing No Yes and generally net settleable liquidity and fair value Meet the definition of an executory Yes A contract is signed upfront but no Yes A contract is signed upfront but no contract ie promise to do money or goods change hands until later money or goods change hands until later something in the future where neither party has yet performed Meet the definition of a derivative Yes The value of the contract depends upon Yes The value of the contract depends upon ie value depends on underlying the value of the underlying eg inventory the value of the underlying eg inventory little or no upfront investments and there is no upfront investment and it will be there is no upfront investment and it will be settled in future settled in the future settled in the future Perspective for accounting purposes Generally accounted for as an unexecuted Generally accounted for as a derivative contract and not recognized until the unrecognized and measured at FVNI underlying nonfinancial item is delivered Accounted for as an executory contract under Derivative accounting does not apply to these IFRS where there is no net settlement feature contracts either because they are not exchange or where one exists but company expects to
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