Answer to Question 1
A Financial instrument can be described as a monetary contract between two or three parties. These contracts can be traded, created, modified and settled. These instruments range from checks, drafts bonds, and shares bills of exchange to futures or an options contract. These instruments have a legally binding agreement regarding payment of money (“Australian Accounting Standards Board (AASB) – Home”, 2017). Financial instruments represent the legal agreement and can be real or virtual. A financial instrument gives rise to assets of an entity and a financial liability of another entry. A financial asset would include cash, or a contractual right to receive cash or equivalent, whereas on the other hand, a financial liability would include an obligation to pay money to the second party or to exchange assets or liabilities with another being under unfavourable potential conditions. It also includes contracts which may be settled using the entity`s personal assets.
Other than a liability or an asset financial instrument, financial instruments can also be an equity instruments. Equity instrument can described as a contract that supports an interest in the assets of another being after subtracting all the liabilities of the being.
As mentioned earlier, financial instruments can be divided with respect to asset classes also depending on the fact whether they are equity based or debt based. Short term instruments based on debt`s duration is for one year or less. Examples of this kind include T-Bills, commercial paper, certificates of deposits, forward based agreements and interest rate futures. Long-term liability based financial instruments are loans, futures bond, interest rate swaps and interest rate options (“Television Education Network services the professional development needs of lawyers, accountants, business and finance executives.”, 2017).
Physical assets such as plant and machinery cannot be termed as financial instruments. This is because possession of the assets allows the organization to generate the cash or allow inflow of another asset but that does not give a present right to receive another financial asset or cash.
Financial instruments may be classified under two sub headings: cash- instruments which are the primary ones and derivative instruments. Cash instrument`s value can be directly influenced and determined by the market. Derivative`s value is based on the value of the underlying asset or instrument (“The impact of AASB 9 on financial investments — Moore Stephens”, 2017). Markets directly influence and determine the value of cash instruments.
However, a third categorization of financial instruments is the compound financial instruments. It consists of both equity and financial liability component. The issuer has to determine whether to disclose the instrument as an equity or a liability. They need to consider the economic implication of the disclosure rather than considering its legal form.
One important characteristic that can be used to differentiate a liability from an equity is that an instrument is a financial liability if there exists a contractual obligation to pay an entity or give some other financial asset to them. It may also include exchange of another financial instrument under unfavourable potential conditions (AASB, 2014). In simple terms, an instrument is equity if there exists no obligation to pay anybody but a choice. I f the issuer is not bound by obligation but by convenience then the instrument is an equity.
Answer to Question 2
In another case if an instrument maybe settled using the issuer`s own equity instrument and there exists an obligation from the issuer`s to deliver a particular number of its equity instruments then, in this case this can be described as a financial liability.
We can consider an example to understand the concept better.
ABC Limited has entered an agreement With XYZ Limited to provide shares worth $5 million to XYZ, based on market value at a future date. If during the time when the agreement has been formed, the price of shares is $5 then ABC would have to provide 1000000 shares in case the market price remains static. However, if the market price falls to $4 per share then ABC would have to provide more shares to XYZ- 1250000.
As it can be witnessed that, this serves as a risk to ABC Limited as XYZ will receive $5 million in shares irrespective of the market price. These instruments hence, serve as a financial liability to ABC Ltd, as the exchange or transfer of a number of shares will always pose the threat of a greater loss. From XYZ`S perception this is a financial asset.
Another case of compound financial Instruments is the preference shares. These shares can be en-cashed or redeemed for cash and thus this instrument is a debt to the issuer rather than equity. When the choice to distribute to shareholders lies with the issuer then the shares are equity for him (Fargher et al., 2016). In case the preference shares are classified as debt then their periodic payments are identified as interest expenses, which have an effect on the profit and tend to reduce it. On the other hand, if they are classified as equity then the payments to the shareholders are considered dividends and they do not have an impact on the reported profits
It needs to be noted that classification of the instruments by the user is important and that the fair value of the component must be determined.
A forward exchange rate contract is used to reduce the uncertainty of fluctuation for the exchange rates (Hodder, 2014). Silver Ltd entered into this contract to purchase us$ 600000 at the rate of A$ 1=0.69US$. This rate was the spot rate of the day.
Hence, as Silver Ltd got into a contract,
In order to purchase 600000 US$, the company would have to pay-
=600000/ 0.69
=869565 A$ approximately.
As stated on the second day the spot rate was A$= US$ 0.65. If Silver Ltd had not entered into the forward contract then, it would have had to pay-
=600000/0.65
=923078 A$ approximately.
Hence, by entering into the contract, Silver Ltd gained A$ 923078-869565=53513 A$
In the question, it has been stated that current price of Hutchinson Ltd’s shares is $50 per share. Pembroke wants to sell these shares to acquire cash for the company. It gets into a future contract with the position of a seller. The price is 52$.
Ten months later the price of the shares came down to 45$ and the market price of a future with Hutchinson is 48$
Hence, on entering a future contract at 52$ , Pembroke Ltd has gained. If it would have not entered into a contract, then it would have sold its shares at 45$. Hence, Pembroke Ltd has gained –
52-45=7$ per share
Total gain= 7$* 2000
= 14000$.
A futures contract is an agreement made on the floor of a futures exchange to sell or buy a particular financial instrument or commodity at a price that is set previously or predetermined at a specific time in future. Individuals and companies to safeguard them against loss due to fluctuation of process in the future use the contract (Hodder, 2014).
Pembroke Ltd entered into a future contract to hedge against probable future losses. The stock market is volatile which means the price fluctuations are extremely high. Pembroke wanted to make sure that it does not incur losses and achieve high returns against its investments. The company would not have been in a better position had it not entered into futures because current market of $50 fell to $ 45.
In that case he would have lost $10000 (Loss of $5/ share*2000shares).
Therefore, it can be stated that it was a good decision of the firm to enter into a future contract as it provided Pembroke with higher share prices and more capital for investment.
References
AASB, C. A. S. (2014). Financial Instruments. Project Summary.
Australian Accounting Standards Board (AASB) – Home. (2017). Aasb.gov.au. Retrieved 3 November 2017, from https://www.aasb.gov.au/
Fargher, N., Sidhu, B., Tarca, A., & Van Zyl, W. (2016). Accounting for financial instruments with characteristics of debt and equity: Finding a way forward.
Hodder, L. D. (2014). Financial Reporting for Financial Instruments.
Television Education Network services the professional development needs of lawyers, accountants, business and finance executives.. (2017). Television Education Network.. Retrieved 3 November 2017, from https://www.tved.net.au/index.cfm?SimpleDisplay=PaperDisplay.cfm&PaperDisplay=https://www.tved.net.au/PublicPapers/June_2006,_Corporate_Education_Channel,_The_New_Financial_Instruments_Standard.html
The impact of AASB 9 on financial investments — Moore Stephens. (2017). Moorestephens.com.au. Retrieved 3 November 2017, from https://www.moorestephens.com.au/news-and-views/august-2016/the-impact-of-aasb-9-on-your-financial-investments
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