International Accounting

Standards

IAS 32 Financial Instrument

Disclosure
Preview

This module looks at

• The presentation of financial instruments
• And some of the disclosures that need to
be made about those instruments.

2
Objective

To explain how financial instruments

should be presented in the financial
statements and some of the disclosures
that need to be made about those
instruments.

3
Scope
IAS 32 applies to financial instruments (whether
recognized or unrecognized) other than:
• Interests in subsidiaries, associates and joint
ventures (IAS 27, 28, 31)
• Rights and obligations under leases (IAS 17)
• Rights and obligations under insurance contracts
(Insurance project)
• Employer’s assets and liabilities under employee
benefit (plans IAS 19)

4
Continued-Scope
• Equity instruments issued by the reporting
enterprise
• Financial guarantee contracts, including
letters of credit, that provide for payments in
case of debtor’s failure (IAS 37)
• Contracts for Contingent Consideration in a
Business Combination (IAS 2, par. 65-76)
• Weather derivatives – contracts requiring
payment based on a climactic, geological, or
other physical variables (basically a form of
insurance contract)
5
IAS 32 Requirements

IAS 32 prescribes:
• Requirements for the presentation of
“on-balance-sheet” (recognized) financial
instruments.
• Disclosures about both recognized and
unrecognized financial instruments

6
Financial Instrument

A financial instrument
• Is a contract that gives rise to both a
financial asset of one enterprise and a
financial liability or equity instrument of
another enterprise.

7
Financial Asset

A financial asset is any asset that is:

• Cash;
• A contractual right to receive cash or another
financial asset from another enterprise;
• A contractual right to exchange financial
instruments with another enterprise under
potentially favorable conditions; or
• An equity instrument of another enterprise.

8
Financial Liability

A financial liability is any liability that is a

contractual obligation:
• To deliver cash or another financial asset to
another enterprise; or
• To exchange financial instruments with
another enterprise under potentially
unfavorable conditions.

9
Equity instrument

is any contract that evidences a residual

interest in the assets of an enterprise
after deducting all of its liabilities.

10
Types of Financial Risks
• Price risk – the risk of changes in value through
changes in currency exchange rates, interest rates and
market prices.
• Credit risk – the risk one party to a financial
instrument will fail to discharge an obligation and
cause the other party to incur a financial loss.
• Liquidity risk or funding risk – the risk that an
enterprise will encounter difficulty raising funds to
meet commitments.
• Cash flow risk – the risk that the future cash flows
associated with a monetary financial instrument will
fluctuate in amount. For example, when a debt
instrument carries a floating interest rate.
11
Basic Types of Financial
Instruments
Primary financial instruments –
examples are receivables, payables,
equity securities, loans

Derivatives – examples are

forward/futures, options, swaps

12
Continued-Basic Types of…

Derivative – A financial instrument:

1) Whose value changes in response to changes 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 (which is known as the “underlying”),
2) That requires no initial net investment or little
initial net investment, and
3) That is settled at a future date.

13
Basic types of derivatives
Forwards/Futures
– a (standardized) contract which forms an obligation for one
party to buy, and the other to sell, a specific asset, currency or
interest rate for a fixed price at a future date.
Options
– A contract between two parties, which gives the buying party
the right but not the obligation to buy or sell an asset,
currency or interest rate for a specified price.
Swaps
– An agreement made by two parties to exchange a series of
cash flows (for example, fixed interest rate payments for
floating-rate payments) in the future.

14
Classification of an Instrument as
Financial Liability or Equity

An instrument must be classified in

accordance with the substance of the
contractual arrangements giving rise to
the instrument and the definitions of
“financial liability” and “equity
instrument”.

15
Continued-Classification of an…
Example:
• A preferred share that provides for mandatory
redemption for a fixed or determinable amount at
fixed or determinable dates meets the definition of
“financial liability”.
The critical feature in differentiating a financial
liability from an equity instrument:
• Is the existence of a contractual obligation of one
party either to deliver cash or another financial
asset to the other party (the holder) or
• To exchange another financial instrument with the
holder under conditions that are potentially
unfavorable to the issuer.
16
Classification of Compound
Instruments
For a compound financial instrument, the
component parts must be classified
separately.
• For example, a debt instrument that provides the
holder with an option to convert the instrument
into shares of the issuer (e.g., a bond which can be
converted into common shares) comprises the
following components:
o An obligation to repay interest and principal, which would
be classified as a financial liability; and
o An embedded call option granting the holder the right to
convert to shares, which would be classified as equity.

17
Continued-Classification of…
IAS 32 requires the issuer of such a financial
instrument to present the liability component
and the equity component separately on the
balance sheet from their initial recognition.
• The fair value of the liability component is the
present value of the contractually determined
stream of future cash flows discounted at the rate
of interest applied by the market.
• The equity instrument is an embedded option to
convert the liability into equity of the issuer.

18
Continued-Classification of…
• The fair value of the option comprises its time
value and its intrinsic value, if any.
• The intrinsic value is the excess, if any, of the
fair value of the underlying financial instrument
over the contractual price at which the
underlying instrument is to be acquired, issued,
sold or exchanged.
• The time value is fair value less intrinsic value.
• It is uncommon for the embedded option in a
convertible bond or similar instrument to have
any intrinsic value on issuance.

19
Interest, Dividends, Losses and
Gains
• The classification of interest, dividends, losses
or gains depends on the classification of the
financial instrument that the interest,
dividends, losses or gains relate to.
• If they relate to a financial instrument or
component part classified as a financial
liability, then the interest, dividends, losses or
gains are reported in the income statement.

20
Offsetting Financial Assets and
Financial Liabilities
Financial assets and financial liabilities
should be offset and the net amount
reported in the balance sheet when the
enterprise:
• Has a legally enforceable right to set off the
recognized amounts; and
• Intends either to settle on a net basis or to realize
the asset and settle the liability simultaneously.

21
General Disclosure Requirements

An enterprise must disclose:

• A description of the financial risk
management objectives and policies it
adopts,
• Including its hedging policies for each
major type of forecasted transaction for
which hedge accounting is used.

22
Continued-General Disclosure…

Enterprises are also encouraged to disclose

information about:
• The extent to which financial instruments
are used, and
• The associated risks and business purposes
served.

23
Continued-General Disclosure…

For each class of financial asset, financial

liability and equity instrument, (both
recognized and unrecognized), the enterprise
must disclose:
• Information about their extent and nature,
including significant terms and conditions that
may affect future cash flows; and
• The accounting policies and methods adopted,
including the criteria for recognition and the basis
of measurement applied.

24
Interest Rate Risk

For each class of financial asset and

financial liability, an enterprise must
disclose information about its exposure
to interest rate risk, including:
• Contractual repricing or maturity dates
(whichever dates are earlier); and
• Where applicable, the effective interest
rates/yields.

25
Continued-Interest Rate Risk
An enterprise indicates which of its financial
assets and financial liabilities are:
• Exposed to interest rate price risk, such as
monetary financial assets and financial liabilities
with a fixed interest rate;
• Exposed to interest rate cash flow risk, such as
monetary financial assets and financial liabilities
with a floating interest rate that is reset as market
rates change; and
• Not exposed to interest rate risk, such as some
investments in equity securities.

26
Credit Risk
For each class of financial asset, an enterprise
should disclose information about its exposure to
credit risk, including;
• The amount that best represents its maximum credit
risk exposure at the balance sheet date, without taking
account of the fair value of any collateral, in the event
other parties fail to perform their obligations under
financial instruments; and
• Significant concentrations of credit risk. (IAS 32.66)
It is also desirable for an enterprise to disclose the
terms of the master netting arrangements that
determine the extent of the reduction in its credit
risk.
27
Fair Value

For each class of financial asset and

financial liability, an enterprise must
disclose information about fair value.
Where it is not practicable to determine
fair value with sufficient reliability, the
fact must be disclosed.

28
Financial Assets Carried at an
Amount in Excess of Fair Value
Where a financial asset is carried at
amount that exceeds its fair value, an
enterprise must disclose;
• The carrying amount and the fair value of
either the individual assets or appropriate
groupings of those individual assets; and
• The reasons for not reducing the carrying
amount to fair value.

29
Hedges of Anticipated Future
Transactions
When an enterprise has accounted for a financial
instrument as a hedge of risks associated with
future transactions, it should disclose:
1. A description of the anticipated transactions, including
the period of time until they are expected to occur;
2. A description of the hedging instruments ; and
3. The amount of any deferred or unrecognized gain or
loss and the expected timing of recognition as income
or expense (IAS 32.91).
4. Describe the enterprise’s financial risk management
objectives and policies.

30