lecture 1b- sem2-investments in equity securities.pdf

8/14/2019 Lecture 1b- SEM2-Investments in Equity Securities.pdf

1/23

LECTURE 1b

ACCOUNTING FOR

INVESTMENTS INEQUITY SECURITIES

By

Dr Mazni Abdullah, CA (M), PhD (Stirling), MBA (Malaya), B Acc (Malaya)

Session 2012/2013


2/23

Which Financial Reporting Standards

should be used?

Financial Reporting Standards effective 1/1/2013

FRS Title Effective Date

MFRS 132 Financial Instruments:Presentation

1 Jan 2012

MFRS 139 Financial Instruments:

Recognition & Measurement

1 Jan 2012

MFRS 7 Financial Instruments:Disclosure

1 Jan 2012

MFRS 9 Financial Instruments 1 Jan 2013


3/23

Derivatives

Define as: financial instrument / other contracts:

a) Whose value changes in response to the change in a specifiedinterest 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 thatwould 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


4/23

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.


5/23

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


6/23

SWAP CONTRACTS

A contract between 2 parties to exchange cash flows in aspecified 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 floatingrate 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.


7/23

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


8/23

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 potentiallyfavorable financial assets

For the writers/issuers potentially unfavorable financial

liability


9/23

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.


10/23

Journal entries

Quarter 1

Dr Derivative asset stock options

770k

Cr Cash 770k

(to record purchase of stock options)

Dr Derivative asset stock options

270k

Cr Gain on stock options 270k

(to FV options & recognise gain in

profit/loss)

Quarter 2

Dr Derivative assetstock 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)


11/23

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.


12/23

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 flowsof 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 embeddedderivative 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.


13/23

EMBEDDED DERIVATIVES

If an embedded derivative is separated, thehost 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.


14/23

EMBEDDED DERIVATIVESE.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


15/23

EMBEDDED DERIVATIVESMFRS139. 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 cashflows 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 forapproximately its amortised cost.


16/23

EMBEDDED DERIVATIVES

MFRS139.12 : if it is unable to measure theembedded 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).


17/23

EMBEDDED DERIVATIVES Eg.

A Bhd purchased CLS (convertible loan stock) of X Bhd for RM 1.5 millionon 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 200,000

Cr Fair Value Gain 200,000


18/23

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 fairvalue/ cash flows are expected to offset changes in the fair

value or cash flows of a designated hedged item.


19/23

MFRS139 Hedge Accounting Para 88 hedged accounting is permitted if all the following

conditions are met:

i. There is formal documentation of the hedging relationship and the

entitys risk management and strategy for undertaking the hedge

ii. 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 instrumentsthe

results are within a range of 80% to 125%)

iii. For cash flow hedges, a forecast transaction that is subject of the

hedge must be highly probable.


20/23

MFRS139 Hedge AccountingScenario 1:

On 1 June 2011, A Bhd enters into a hedge through a derivative for anexposed 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


21/23

MFRS139 Hedge AccountingScenario 1:


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:


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.


22/23

MFRS139 Hedge AccountingIllustration (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.


23/23

MFRS139 Hedge Accounting

Journal entries:

31/3/x1

Dr Investment in debt security 100,000

Cr Cash 100,000

31/12/x1Dr Investment in debt security 10,000

Cr FV reserve 10,000

31/12/x2

Dr Derivative Asset 6,000

Cr FV Gain 6,000

Dr FV Loss 6,000

Cr Investment in debt security 6,000

lecture 1b- sem2-investments in equity securities.pdf

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