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What is a financial asset?
- Equity instruments of another entity (e.g. shares),
- Contractual right
We move the financial assets
To receive cash or another financial asset of another entity (e.g. trade receivable);
- To exchange financial assets or financial liabilities with other entities under potentially favourable conditions (e.g. foreign currency forward contract with a positive outcome – derivative asset)
- The contract settled with a variable amount of own equity instruments (very simplified). If this would be settled with a fixed amount of own equity instruments, then it would have been an equity instrument, not a financial asset.
Please note that the contractual rights to receive an asset other than cash or a financial asset of another entity is NOT a financial instrument.
Example – financial instrument or not?
Imagine you ordered XY barrels of petrol with delivery in 3 months at market price valid at the time of delivery. You have 2 options:
Take physical delivery (=petrol)
Instead of physical delivery, you settle in cash (pay or receive the difference in market prices between the date of the contract and the time of delivery).
If you intend to take physical delivery, then it’s NOT a financial instrument (if you have no history of similar contracts settling in cash). It’s a regular trading contract because you will NOT receive cash or a financial asset of another entity. But, if you intend to settle in cash, it’s a financial instrument and you need to recognize a derivative from day 1.
What is a financial liability?
A contractual obligation
To deliver cash or another financial asset to another entity (e.g. loan taken, trade payable), or to exchange financial assets or financial liabilities other than the entity’s own equity under potentially unfavourable conditions.
The contract settled with a variable amount of own equity instruments (very simplified). If this would be settled with a fixed amount of own equity instruments, then it would have been an equity instrument, not a financial liability.
Why variable amount, not fixed?
Why is the fixed amount of own equity instruments excluded when defining the financial assets and liabilities? It is probably because the nature of such transactions is very close to equity issuance or repurchase.
EXAMPLES: CONTRACTS FOR SHARES TO PAY FIXED LIABILITIES
- a contract to deliver as many of the undertaking’s own equity instruments as are equal in value to $100,000, and
- a contract to deliver as many of the undertaking’s own equity instruments as are equal in value to the value of 100 ounces of gold.
Such contracts are financial liabilities, even though the undertaking must, or can, settle it by delivering its own equity instruments.
So let’s get back to the important question of why do we really care what is classified as a financial asset or financial liability and/or equity. The question boils down to the potential of a future loss. The Barings case illustrated an extreme example whereby one person working in a bank and with seemingly unlimited access to the financial markets was able to independently bring down a very significant bank. The ability to hide the transaction, totally bypass all internal controls and be able to continue executing transactions in an attempt to recover his position clearly demonstrated the need for stronger regulatory compliance. Irrespective however of that individual’s arrogance was management’s total failure to ensure that no one trader could operate totally independently without apparent supervision. However, notwithstanding these obvious organizational weaknesses let’s get back to the IFRS when it comes to handling/accounting for financial instruments.
In reality when we talk about financial instruments what is really on the agenda is how to account for derivatives under the Framework’s ‘transparency’ umbrella. Does this imply that trading derivatives is very unwise and should be prohibited, on the contrary absolutely not. There are two positions when it comes to derivatives; a ‘naked/speculative’ position and a hedged position. And when it comes to naked positions both the potential gain and the potential risk are greater. Oh, and should be no surprise, the Barings case was all about trading ‘naked’ derivatives.
So what are these financial instruments, these derivatives:
Forward contracts / Futures
Forward contracts are legally binding obligations to deliver or take delivery of a specified asset on a contractually agreed-upon date and price. Futures contracts also require the contracting parties to deliver or take delivery of an asset on a future date. However, other terms of the futures contract differ from the forward contract making the futures contract more useful at times than the forward contract, depending upon the circumstances of the firm, and less useful at other times.
(AMA Managing Financial Risk)
Option contracts give the option holder (also called the option owner) the right, but not the obligation, to buy or sell an asset at a specified price, called the strike price, on or through a specified date, called the option expiration date. The people who stand ready to buy or sell the asset if the option is exercised are called option writers and are legally obligated to fulfill the terms of the option
agreement. Unlike the option holder, option writers cannot walk away from the option if the price of the asset moves against them.
(AMA Managing Financial Risk)
Swaps are contractual arrangements whereby two parties, called swap counterparties, effectively agree to swap payments on specified obligations issued by the counterparties. Interest rate and currency swaps are the most common types of swap arrangements. For example, in an interest rate swap, counterparty A might issue fixed-rate debt and counterparty B floating-rate debt. Then, the respective payments would be swapped through a financial intermediary with counterparty A making floating-rate payments to the financial intermediary and receiving fixed-rate payments while counterparty B makes fixed-rate payments to the intermediary and, in turn, receives floating-rate payments. The effective outcome is to transform A’s fixed-rate debt into floating-rate debt for A and B’s floating-rate debt into fixed-rate debt for B—that is, a swap.
(AMA Managing Financial Risk)
When we create a derivative position we’re selecting a directional movement.
Accounting Theory – Advanced Part 23 (IAS 33 Financial Instruments Presentation)
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