LECTURE 1b

ACCOUNTING FOR INVESTMENTS IN EQUITY SECURITIES

By
Dr Mazni Abdullah, CA (M), PhD (Stirling), MBA (Malaya), B Acc (Malaya) Session 2012/2013

Which Financial Reporting Standards should be used?

Financial Reporting Standards effective 1/1/2013
FRS MFRS 132 MFRS 139 MFRS 7 MFRS 9 Title Financial Instruments: Presentation Effective Date 1 Jan 2012

Financial Instruments: 1 Jan 2012 Recognition & Measurement Financial Instruments: Disclosure Financial Instruments 1 Jan 2012 1 Jan 2013

Derivatives
Define as: financial instrument / other contracts: a) Whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (underlying); b) That requires no initial net investment/ an initial net investment that is smaller than would be required for other types of contracts that would be expected to have similar response to changes in the market conditions; and c) That is settled at a future date

Eg: forward contracts, futures contracts, swap contracts, option contracts

FORWARD CONTRACTS
Contract between 2 parties to buy/sell an asset at a price which is fixed at the contract date but the settlement is at a forward date. No upfront payment on the date of the contract. The agreed price is called the delivery price. E.g.: foreign currency forward contract
An entity may buy/ sell the foreign currency forward (eg. 6 months forward) at a forward price fixed today, but the settlement is in 6 months time.

FUTURES CONTRACTS
A contract to buy/sell an asset and the ultimate settlement is at a future date. In a standard lot, quality or grade Traded on futures exchanges (deal with the broker) Need a performance margin account for trading on futures contracts

SWAP CONTRACTS
A contract between 2 parties to exchange cash flows in a specified future period. The most common type: plain vanilla interest rate swap one party agrees to pay a stream of fixed rate interest on a notional amount and in return, receives a stream of floating rate interest based on the same notional amount for a specified time period. It can be used to hedge interest rate risk by converting the cash flows of a floating rate bond to those of a fixed rate bond (or vice versa). Cross currency swap exchanging principal and interest payments in one currency for principal and interest payments in another currency. It can be used to hedge currency risk in a debt instrument denominated in a foreign currency.

FORWARDS, FUTURES, SWAPS

Rights and Obligations (RO) Subsequent to initial recognition- the FV of RO will change 1. FV of rights > FV of obligation = Favorable
GAIN Derivative is recognised as an ASSET

2. FV of rights < FV of obligation = Unfavorable

LOSS Derivative is recognised as a LIABILITY

OPTION CONTRACTS
A contract that gives the holder the right (no obligation) to buy/sell an asset at a certain price (known as strike/exercise price), by a certain date and under certain terms &conditions. Call option gives the holder the right to buy an asset Put option gives the holder the right to sell an asset European option can only be exercised on the maturity date American option- can be exercised at any time For the holder, the option contracts will always be potentially favorable financial assets For the writers/issuers potentially unfavorable financial liability

E.g. (adapted from TLT 2012)

At the beginning of quarter 1, KPP Bhd purchases 1,000,000 stock options of Lenting Bhd in anticipation that Lenting Bhds ordinary shares would rise in the next 6 months. The strike price of the options is RM6.00 and they expire in 12 months time. The price paid for the options is RM0.77 per option. At this date, Lenting Bhd mother shares have a market price of RM6. The mother shares have an expected volatility of 30% and expected dividend yield of 2%. The current risk free rate of return is 4.5%. At the end of the quarter 1, Lenting Bhds ordinary shares are quoted on the Exchange at RM6.60 per share. At the end of quarter 2, the share price increases further to RM7.50 per share. KPP sells the options at the end of quarter 2. Using the Black-Scholes Option pricing model, the value of the option at the end of quarter 1 and 2 are RM 1.04 and RM 1.65 respectively.

Journal entries
Quarter 1
Dr Derivative asset stock options 770k Cr Cash 770k (to record purchase of stock options)

Quarter 2
Dr Derivative asset stock options 610k Cr Gain on stock options 610k (to FV options & recognise gain in profit/loss) Dr Cash 1650k Cr Derivative asset-stock option 1650k (to derecognise stock options on disposal)

Dr Derivative asset stock options 270k Cr Gain on stock options 270k (to FV options & recognise gain in profit/loss)

Accounting for Derivatives

It can be summarised as follows: 1. On contract date recognise the derivative at the Net FV of nil (if there is no outlay) or at the premium paid/received (for option derivatives). 2. Remeasure the derivative to FV at each reporting date & recognise change in value as a gain/loss in profit or loss (unless hedge accounting applies). 3. Remeasure the derivative on the date it is closed out or on maturity date and recognise gain/loss (unless hedge accounting applies); and 4. Close out the contract & derecognise the derivative upon settlement.

EMBEDDED DERIVATIVES
is a component of a hybrid (combined) instrument that also includes a non-derivative host contract, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.

MFRS 139. 11: An embedded derivative shall be separated from the host contract and accounted for as a derivative if and only if:
a) The economic characteristics & risks of the embedded derivatives are not closely related to the economic characteristics and risks of the host contracts b) A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and c) The hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss.

EMBEDDED DERIVATIVES
If an embedded derivative is separated, the host contract will be accounted for under MFRS139 if it is a financial instrument or in accordance with other appropriate MFRSs if it is not a financial instrument.

EMBEDDED DERIVATIVES
E.g. adapted from TLT (2010): Entity A enters into a contract with a contractor to build a factory at a price of RM 1 million. Entity A currently owns 100,000 equity shares of Lenting Bhd that have a fair market value of RM 1 million. In the contract with a contractor, the contractor has an option of choosing settlement either in cash or requiring Entity A to deliver the 100,000 Lenting shares upon completion. _______________________________________________________________ Embedded derivative in the construction contract Entity A has a call option on Lenting shares Entity A must separate the written call option from the host construction contract Call option derivative under MFRS139 Host contract (contract to build a factory) MFRS116 PPE

EMBEDDED DERIVATIVES
MFRS139. 11 A: If a contract contains one /more embedded derivatives, an entity may designate the entire hybrid (combined) contract as a financial asset or financial liability at fair value through profit or loss (FIFVPL) unless:
a) The embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or b) It is clear with little/ no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative (s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay to the loan at for approximately its amortised cost.

EMBEDDED DERIVATIVES
MFRS139.12 : if it is unable to measure the embedded derivative separately either at acquisition/ at a subsequent financial reporting date, it shall designate the entire hybrid (combined) contract as at fair value through profit or loss (held for trading financial isntrument).

EMBEDDED DERIVATIVES
Eg. A Bhd purchased CLS (convertible loan stock) of X Bhd for RM 1.5 million on 1 July 2011. A Bhd has the ability and intention to hold the loan stock until the maturity date. Assuming the FV of the conversion option is RM300,000 and on 31 December 2011, the conversion right has a fair value of RM500,000 ______________________________________________________________ 1 July 2011: Dr Investment in loan stock 1,200,000 Dr Investment in derivative 300,000 Cr Cash 1,500,000 31 Dec 2011: Dr Investment in derivative Cr Fair Value Gain

200,000 200,000

MFRS139 Hedge Accounting

Defined as designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item. Hedged item an asset, liability, firm commitment, highly probable forecast transaction, or net investment in a foreign operation that: (a) exposes the entity to risk of changes in fair value/ changes in future cash flows; and (b) is designated as being hedged. Hedging instrument a designated derivative whose fair value/ cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.

MFRS139 Hedge Accounting

Para 88 hedged accounting is permitted if all the following conditions are met:
i. ii. There is formal documentation of the hedging relationship and the entitys risk management and strategy for undertaking the hedge The hedge is expected to be highly effective (i.e. Changes in fair value/cash flows of the hedged item are expected to be almost fully offset by the changes in the FV/ CF of hedging instruments the results are within a range of 80% to 125%) For cash flow hedges, a forecast transaction that is subject of the hedge must be highly probable.

iii.

MFRS139 Hedge Accounting

Scenario 1: On 1 June 2011, A Bhd enters into a hedge through a derivative for an exposed asset position. The FV calculation of the hedging instrument and hedged items as at 31 Dec 2011 as follows: Gain in value of the hedging instrument: RM100,000 Loss in value of the hedged item: RM 75,000 _______________________________________________________________ Scenario 2: On 1 June 2011, A Bhd enters into a hedge through a derivative for an exposed asset position. The FV calculation of the hedging instrument and hedged items as at 31 Dec 2011 as follows: Gain in value of the hedging instrument: RM100,000 Loss in value of the hedged item: RM110,000

MFRS139 Hedge Accounting

Scenario 1: Gain in value of the hedging instrument: RM100,000 Loss in value of the hedged item: RM 75,000 = 75000/100,000 = 75% or 100,000/75,000 = Hedge is ineffective Hedge accounting is not permissible. ____________________________________________________________ Scenario 2: Gain in value of the hedging instrument: RM100,000 Loss in value of the hedged item: RM110,000 = 110,000/100,000 = 110% or 100,000/110,000 = 91%

Hedge is effective

Hedge accounting is permissible.

MFRS139 Hedge Accounting

Illustration (NEJ, 2012): ABC Bhd purchases a fixed interest debt security for RM100,000 on 31 March 20x1 and classifies it as AFS investment and adopts the policy of taking the gain/loss on FV adjustment directly to equity. Due to a decline in the market interest rate, the FV of the debt security increases to RM110,000 as at 31 Dec 20x1. To protect the value of RM110,000, ABC enters into a hedge by acquiring an interest swap on 1 January 20x2. Due to an increase in the market interest rate, the FV of the debt security declines by RM6000 and the fair value of the derivative interest swap increases by RM6,000 as at 31 Dec 20x2.

MFRS139 Hedge Accounting

Journal entries: 31/3/x1 Dr Investment in debt security Cr Cash 31/12/x1 Dr Investment in debt security Cr FV reserve 31/12/x2 Dr Derivative Asset Cr FV Gain Dr FV Loss Cr Investment in debt security 100,000 100,000 10,000
10,000

6,000
6,000

6,000
6,000