课件说明教案msc fa1lecture

1、1MN50318Financial Accounting 1 Lecture 5David BenceFINANCIAL INSTRUMENTS Introduction (1)Rules cover normal instruments such as shares and bonds and derivatives such as securitised loans, futures, swaps and optionsMany companies have lost millions by incorrectly managing derivatives e.g. Barings in

2、1994The banking collapse of 2007 and 2008 was due to derivative speculation e.g. Lehman Bros in 2008 Changes to accounting rules has led to large liabilities on statement of positions, increased perceptions of risk and an erosion of confidenceDifficult to know the correct answer as many gains and lo

3、sses are unrealised and can reverseHard to distinguish between speculation and hedging2FINANCIAL INSTRUMENTS Introduction (2)FRS13 issued in the UK in 1998 following the Barings scandal the UK was the first to try to tackle this area IAS 32 issued in 1995 and revised in 2003 (not withdrawn!) - requi

4、red disclosure of financial instruments. Definitions kept after revision.IFRS7 Financial Instruments: Disclosure was issued in August 2005 and replaced IAS32s disclosure rulesIAS39 issued in 2004 and subject to much controversy not all parts adopted by EC (therefore throwing 2005 convergence into di

5、fficulties!)IFRS9 replaced IAS39 in 2013 but is being phased in gradually!Rules constantly being rewritten due to the current financial crisis, non adoption of IAS39 by the EU and the discovery of new financial instrumentsI am following your Alexander textbook.3Definitions Financial Instruments (IAS

6、32)Financial Instruments are any contracts that give rise to both a financial asset in one entity and a financial liability in another entityA financial asset might be cash, an equity instrument, a right to receive cash (a receivable or debtor) or another financial asset from another entityA financi

7、al liability is an obligation to deliver cash or another financial asset to another entity. 4Financial Instruments that are not Derivatives5Ordinary SharesPreference SharesDebentures, BondsRepayable at some point in the future?NoYesYesInvestment secured on company assets?NoNoYesGuaranteed payment?No

8、Yes normally fixed dividend that accumulates if not paidYes normally fixed couponTax deductible payment?NoNoYesVoting power?YesPossiblyNoDebt or Equity? (IAS32)Debt is redeemable, carries no votes and receives non-discretionary interest that is tax-deductibleEquity is not redeemable, carries votes a

9、nd has non-tax-deductible discretionary dividendsHybrid instruments, such as convertible debt, need to have their debt and equity elements shown separately6Preference SharesPreference shares are normally included under debt. This is an example of substance over form.However, it depends upon individu

10、al contracts. An irredeemable voting preference share with a variable dividend is probably equity.Clever accountants try to dress debt up as equity to reduce gearing.7Valuation of debtHeld to maturity debt is valued at amortised cost any implied interest on deep discount or zero coupon bonds is reco

11、gnised as a finance costThe fair value of fixed coupon held to maturity bonds will vary but this fair value is only shown in the notes, not recognised in the accountsIf the bond is not intended to be held to maturity then it should be measured at fair value with any gain or loss recognised in e8Valu

12、ation of debtAmortised cost is the amount at which the debt is initially measured plus interest at the effective rate less any interest payments madeEffective interest is the cost of similar debt If debt pays variable interest then fair value = book valueIf debt pays fixed interest then its value wi

13、ll rise when interest rates fall9Bond Valuation Example 1aOn 1.1.X5 V plc issues 1,000 1,000 zero coupon bonds for 826,446. The bond will be redeemed at par on 31.12.X6. On 1.1.X5, V plc intends holding the bonds to redemption. The effective interest rate on the bond is 10% (1m/1.102 = 826,446).How

14、should the bond be accounted for in 20X5 and 20X6?10Answer 1a1.1.X5 DR Cash 826,446 CR Bond 826,44631.12.X5 DR Finance cost 82,645 (10% of 826,446) CR Bond 82,645 (bond now has a book value of 909,091)31.12.X6 DR finance cost 90,909 (10% of 909,091) CR Bond 90,909 (bond now has a book value of 1m).3

15、1.12.X6 Bond repaid Dr loan 1m Cr Bank 1m11Example 1bThe effective interest rate on Vs bonds is 10%Assume that, on 2.1.X5, market interest rates on similar bonds falls to 8% where it remains throughout 20X5.What is the fair value of the bonds on 2.1.X5?Will the company be happy or sad?What disclosur

16、es will be made?12Answer 1bCash flows will be the same:826,446 will be raised and 1,000,000 will be repaidAt 8% interest rates, 1m in two years is worth 1m*(1/1.082 )= 857,338. This is the fair value on 2.1.X5. If the bond is traded, we would expect this to be the market value.Bond investors will be

17、 happy but the company will be sad.On 31.12.X5 the market value of the bonds will be disclosed in the notes - 1m/1.08 = 925,926As the company is holding this bond to maturity the market value is not recognised in the financial statements13Example 1cOn 1.1.X6 V plc think that interest rates might fal

18、l further. They decide to cancel the bonds.They pay 925,926 to bondholders.How would this be accounted for in the financial statements as at 31.12.X6?14Answer 1cOn 31.12.X5 the bond has a book value of 909,091.On 2.1.X6 DR Bond 909,091 DR Finance costs 16,835 and CR Bank 925,926.There will be no bon

19、d in the balance sheet as at 31.12.X6.The firm could now issue new bonds at the lower interest rate, saving money. 15Example 1dInstead of 1c, let us assume that interest rates on similar bonds rise to 12% and the directors of V plc decide to cancel the bonds.How much will they pay to bondholders?How

20、 would this be accounted for in the financial statements as at 31.12.X6?16Answer 1dOn 31.12.X5 the bond has a book value of 909,091.On 2.1.X6 the bond has a market value of 1m/1.12 = 892,857DR Bond 909,091, CR Bank 892,857 CR finance costs 16,234There will be no bond in the balance sheet as at 31.12

21、.X6.The company has gained because interest rates rose but in realising this gain has had to repay debt. 17How Banks make profits when their debt turns badAlthough bonds and debentures are long-term sources of finance, nowadays there are ways of cancelling the bonds or swapping out of them.Banks hav

22、e incredibly high levels of debt (90%+) and change their sources of finance regularly.If a bank it close to collapse its debt will be worthless.Therefore gains on debt can be made, boosting profits!18Alice in Wonderland AccountingOn 4.11.11 RBS announced profits of 2bn. This news was greeted with en

23、thusiasm. They had returned to profit.Closer examination reveals that operating profits were actually down from 726m to 267m. The reason they did so well was that a 2.357bn gain on debt was included as e.Many banks do not hold their debt to maturity and measure it at fair value with gains and losses

24、 going through e. The worse they do, the lower the value of their debt and the more gains they make! How to Value Convertible DebtCalculate the value for the liability componentDeduct this from the value of the instrument as a whole to get the equity option componentThis is done at time of issue and

25、 is not restated as market values changeAdjustments to debt, equity, share premium etc made when conversion takes place or debt is redeemed20Convertible Debt Example (1) On 1.1.X1 F plc issues 1,000 1,000 convertible bonds. The bonds carry an coupon rate of 2% and can be converted into 1,000,000 sha

26、res on 31.12.X3. If conversion does not take place, the bonds will be redeemed on 31.12.X3. Each bond was sold at par. Interest rates on non-convertible similar bonds are 5%. How should the bond be accounted for?21Answer22DateCash Flow Discount factor at 5%Present value 31.12.X120,0000.952419,04831.

27、12.X220,0000.907018,14031.12.X31,020,0000.8638881,076918,302Bond is worth 918,302Therefore equity option is worth 81,698DR Cash 1,000,000CR Liabilities 918,302CR Equity 81,698Convertible Debt Example (2)Suppose the share price on 31.12.X3 is 99p.Would conversion be likely?How would repayment of the

28、debt on 31.12.X3 be accounted for? 23Answer (2)Shares worth 99p but debt worth 1 a share therefore not worth converting.Bonds are repaid at 1,000 each = 1m.DR Bond 1m CR Bank 1m to redeem the bonds.NB Equity option is credited to retained revenue reserves on 31.12.X3.24Interest at 5%Payment at 2%Cre

29、dit bond and debit Profit Closing Book value of bond20X145,91520,00025,915944,21720X247,21120,00027,211971,42820X348,57220,00028,5721,000,00081,698Convertible Debt Example (3)Suppose the share price on 31.12.X3 is 101p.Would conversion be likely?How would a full conversion on 31.12.X3 be accounted f

30、or? 25Answer (3)Shares worth 101p and debt worth 1 therefore worth converting.Dr Bonds 1m Cr Share capital 1mDr Equity Option 81,698 Cr Retained revenue reserves 81,698Economic cost of 1p*1m = 10,000 not accounted for argument for recognising a loss of 10,000 and share premium of 10,000.There is an

31、argument for restating the equity option as the share price changes (substance over form). There is also an argument for restating the whole balance. For example, if share price was 5 in 20X1 then it is highly likely all debt would convert. The whole balance could be shown as equity if we wanted to

32、follow the substance over form concept.26More Banking MadnessIn 2009 Lloyds Banking Group issued 9bn of enhanced capital notes (ECNs) for 7.2bn cash. These are described as tier 2 hybrid debt. ECNs pay a very good rate of interest (15% - 1.35bn per annum!) but were issued below par because of conver

33、sion rights - if Lloyds core tier 1 capital should fall below 5% of total assets, the ECNs convert into (worthless?) equity. Lloyds have accounted for this as debt with an embedded derivative and show 9bn of debt and a 1.8bn long-term financial asset! If conversion did take place equity would have a

34、 book value of 7.2bn. 27Overview of DerivativesA derivative is a financial instrument that derives its value from the price or rate of some underlying item a share, a loan, an interest rate, an exchange rate, a commodity, the weather etcA price is agreed now for a sale or purchase in the future.Deri

35、vatives values change in response to changes in values of the underlying assets and liabilitiesDerivatives are settled (closed out) at a future date. Delivery of the underlying item never takes place.Derivatives can have a zero historical cost but potentially a huge current value therefore they crea

36、te problems in our historical cost accounting system Derivatives have high investment gearingDerivative prices are highly volatile28Derivative MarketsWashington, DC Office of the Comptroller of the Currencys Quarterly Report on Bank Derivatives Activities Second Quarter 2011 Executive SummaryThe not

37、ional value of derivatives held by U.S. Commercial banks increased $5.3 trillion in the second quarter to $249 trillion.82% are interest rate swaps. Fastest growth area is credit default swaps.5 large commercial banks hold 96% of the outstanding amount Bear Sterns had $13 trillion outstanding and we

38、nt bust in March 200829Examples of DerivativesForward foreign currency contractsForeign exchange rate futuresCurrency traded optionsCredit default swapsInterest rate futuresCommodity futuresInterest rate swaps30Hedging Foreign CurrenciesTransaction exposure and economic exposureTransaction exposure

39、= risk due to delays in foreign currency payments or receipts This can be easily identified and hedged by, for example, selling forward currency (e.g. if you are owed foreign currency receipts, sell forward that currency)Economic exposure = exposure not related to a particular transaction e.g. if yo

40、u currency appreciates, then your products will be more expensive on foreign markets compared with competitors31Reducing Transaction ExposureA future or forward costs nothing to sign but binds both parties to the contract.An option costs money (the premium) and gives the buyer the right (but not the

41、 obligation) to buy or sellSay company X will receive dollars in six months time. It can fix the price it will get for its dollars by selling them forward or buying a put option, allowing it to sell.32ExampleCompany X expects to receive $100m in six months time. It can enter into a futures contract

42、allowing the company to sell the dollars at 1:$1 or it can pay 15m for a put option allowing it to sell at 1:$1. Calculate the gain or loss for the future and the option if the exchange rate goes to (a) 1:$2 or (b) 1:$0.5.The real dollars will be worth either (a)50m or (b)200m.Future will obligate t

43、he firm to sell $100m for 100m, giving a (a)50m gain (sell $100m for 100m but buy $100m for 50m) or (b) a 100m loss (sell $100m for 100m but buy $100m for 200m). This matches the real gain or loss. Overall, there is no gain or loss and the firm has fixed its receipt to 100m.The option will be exerci

44、sed if (a) occurs and will expire worthless if (b) occurs. Net cash in will be (a)85m or (b)185m. The firm has insured itself against a loss but kept the upside.33Natural HedgingIf costs and revenues are in the same currency then exchange gains and losses partially offset one another.Likewise, if assets and liabilities are in the same currency then exchange gains and losses partially offset one another.So