BKAR 3033 FINANCIAL ACCOUNTING AND REPORTING 111 (A162)

MINI CASE TOPIC 4 FINANCIAL INSTRUMENTS

DUE DATE: 16 April 2017

QUESTION 1

What is a derivative?

ANSWER 1

A derivative is a financial instrument that derives its value from the value of an
underlying asset, price, rate or index.
Underlying items include equities, bonds, commodities, interest rates, exchange rates
and stock market and other indices. Derivative financial instruments include futures,
options, forward contracts, interest rate and currency swaps.

QUESTION 2

Describe the main risks that pertain to financial instruments.

ANSWER QUESTION 2
The main risks include: market risk, credit risk and liquidity risk.
Market risk is comprised of (1) currency risk the risk that the value of a financial instrument
will fluctuate because of changes in foreign exchange rates; (2) interest rate risk the risk that
the value of a financial instrument will fluctuate because of changes in market interest rates; (3)
other price risk the risk that the value of a financial instrument will fluctuate as a result of
changes in market prices. Market risk embodies the potential for both loss and gain.

Credit risk is the risk that one party to a financial instrument will fail to discharge an obligation
and cause the other party to incur a financial loss.

Liquidity risk is the risk that an entity will encounter difficulty in meeting obligations associated
with financial liabilities. This is also known as funding risk.

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 QUESTION 3

Company A issues redeemable preference shares with a fixed maturity date. The shares are
redeemable only on maturity at the option of the holder. The shares carry a cumulative 6%
dividend.

REQUIRED
Determine whether this financial instrument should be classified as a financial liability or equity
instrument of Company A. Give reasons for your answer.

ANSWER QUESTION 3

This instrument is a financial liability. The issuer has a contractual obligation to pay
dividends (they are cumulative) and to redeem the shares on maturity (holders option).
Cumulative dividends on their own are not enough to cause liability classification
(MFRS 39) but since the shares are redeemable this causes primary liability
classification.

QUESTION 4

View Bhd has the following financial assets (financial instruments) in its book:

(a) Investment held for trading purposes.

(b) Interest-bearing debt instruments that will be redeemed in 5 years.
View Bhd fully intends to hold them until redemption.
(c) Trade receivables.
(d) Derivatives held for speculation purposes.
(e) Equity shares which View Bhd has no intention of selling.

REQUIRED:

How would View Bhd classify its financial assets?

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ANSWER QUESTION 4

Financial assets Classification

Investment held for trading purposes. Financial assets at FVTPL
Interest-bearing debt instruments that will Held-to maturity investments
be redeemed in 5 years. View Bhd fully
intends to hold them until redemption.
Trade receivables. Loan and receivables
Derivatives held for speculation purposes. Financial assets at FVTPL
Equity shares which View Bhd has no Available for sale financial assets
intention of selling. because do not fit in any other
classification.

QUESTION 5

Avery Bhd enters into a forward contract on 30 September 2015 to buy 10,000 tons of platinum
for RM500 on 31 March 2016. The contract was entered into on 30 September 2015 at nil cost.

Avery Bhd does not plan to take delivery of the platinum but to settle the contract net in cash, i.e.
Avery hopes to generate a profit from short term price fluctuations. Assume that the year end is
31 December 2015 and the price of platinum has moved so that making the equivalent purchase
on 31 December 2015 would require Bermuda to spend RM480.

On 31 March 2016, the value of underlying item has changed such that the equivalent purchase
of platinum would now cost RM505.

REQUIRED:
Prepare the journal entries on the contract date, the reporting date and the settlement date.

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ANSWER QUESTION 5
Date Price Fwd price
30 September 2015 500 (forward contract)
31 December 2015 480
31 March 2016 505

30 September 2015(contract date)

Nil

31 Dec 2015 (reporting date)

Dr P/L-loss on FV change(500-480) x 10,000 200,000

Cr Derivative-financial assets 200,000

31 March 20X2 (settlement)

Dr Derivative-Financial asset(505-480)x 10,000 250,000

Cr P/Loss-loss on FV change 250,000

Dr Bank 5,000
Cr Derivative F.asset (505-500) x 10,000 5,000
QUESTION 6

At the beginning of quarter 1, Mutiara Bhd. purchase 100,000 ordinary shares of

Delima Bhd. at RM15 per share inclusive of transaction cost. The investment is
classified as AFS investment and changes in FV are recognised in OCI and remain in
FV reserve. The closing price of Delima Bhd. shares is RM17 at the end of quarter 1.
At the beginning of quarter 2, to protect the value of its investment in Delima Bhd.,
Mutiara Bhd. purchases 200,000 put options that give it the right to sell Delima shares
at RM18 per share within 6 months. The price paid for the stock option is RM0.70.
The hedge risk in this case is the market price of Delima shares. The quoted price for
the shares and options are as follows:
Delima ordinary shares put options
end of quarter 2, RM16.65 RM0.90.
end of quarter 3 RM18.50 expired
end of quarter 4 RM19.00
Beginning of quarter 4, Mutiara Bhd decided to discontinue with the hedging.

REQUIRED:
Prepare the required journal entries and calculate the effectiveness of the hedging
strategy (until expired) at the end of each quarter.

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ANSWER QUESTION 6

Quarter 1
Dr AFS-investment in Delima Bhd shares (15x100,000) 1,500,000
Cr Bank 1,500,000
To record purchase of Delima Bhd shares

Dr AFS-investment in Delima Bhd shares (17-15) (100, 000) 200,000

Cr Other Comprehensive Income(OCI) 200,000
To recognise change in FV in OCI

Quarter 2
Dr Put option on Delima Bhd shares (200,000x 0.70) 140,000
Cr Bank 140,000
To record purchase of put option

Dr Loss on hedge items in Profit/Loss (17-16.65)x (100,000) 35,000

Cr AFS Investment in Delima Bhd 35,000
To recognise loss on changes in FV on hedged items
Dr Put options on DEF shares (0.90-0.70) (200,000) 40,000
Cr Gain on hedging instruments in P/L 40,000
Effective rate of hedging: 35000/40000 = 87.5 %
40000/35000 = 114% , hedging is highly effective

Quarter 3
Dr AFS Investment in Delima (18.5-16.65) x 100,000 185,000
Cr Gain on hedged item in P/L 185,000
To recognise gain on changes in FV on hedged items

Dr Loss on hedging instruments in P/L(0.90 x 200,000) 180,000

Cr Put options on Delima shares 180,000
Effective rate of hedging: 185000/180000 = 102.8%
180000/185000 = 97.3% , hedging is highly effective

Quarter 4
Dr AFS Investment in Delima (19-18.5*100000) 50,000
Cr OCI 50,000
To recognise gain on changes in FV on investment.

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 QUESTION 7

Cille Bhd owns inventories of 10,000 tons of steel which cost RM100,000 on 1
December 2015. If the price of steel falls, Cille Bhd will suffer a loss when they sell
the steel. To minimise this risk, it enters into futures contract to sell 10,000 tons of
stell for RM120,000 on 1 February 2016 (at a price of RM12 per ton).

At the year end of 31 December 2015, the market value of steel is RM9 per ton and
the futures price for delivery on 1 February 2016 is RM11 per ton.

REQUIRED:
a) What is the hedge item?
b) What is the hedging instrument?
c) What is the impact of the fair value hedge on the financial statement of Cille
Bhd at 1 December 2015?

ANSWER QUESTION 7

(a) The hedge item is inventories of steel

(b) The hedge instrument is futures contract

(c) Impact of fair value hedge:

Hedge item: steel

Cost of steel RM100,000
Price of steel at 31 December 2015 is RM9 x 10,000 tons 90,000
Loss on FV changes 10,000

Dr Loss on Fv hedge 10,000

Cr Inventory 10,000

Hedging instruments: futures contract

Futures contract on 1 Feb 2016 at RM12 x 10,000 120,000
Futures price on 1 Feb 2016 RM11 x 10,000 110,000
Gain on futures 10,000

The overall effect on 31 December 2015 is nil.

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 QUESTION 8

On 1 May 2016 Mahsuri Bhd entered into a forward contract with Bina Dunia Bhd to
purchase 2,000,000 shares of Pujangga Bhd in an antipication that the share price of
Pujangga Bhd will rise in the next 6 months. The forward contract matures on October
2016. Financial year end for Mahsuri Bhd is on 30 June.

The share price of Pujangga Bhd at 1 May 2016 is RM6 per share. Assume that the 6-
month risk free rate is 8 per cent and Pujangga Bhd has an annual dividend yield of 4
per cent.

The share prices of Pujangga Bhd changes as follow:

Date price per share

1 May 2016 RM6
30 June 2016 RM6.20
31 October 2016 RM6.50

REQUIRED:

(a) Compute the forward price of the forward contract on the contact date, 1 May
2016. Prepare the required journal entries.
(b) Compute the forward price of the forward contract and calculate any gain or loss
at year end, 30 June 2016. Prepare the journal entries.
(c) Compute the forward price of the forward contract and determine any gain or
loss at maturity, 31 October 2016. Prepare the journal entries.
(d) Assume a net settlement basis, record the accounting entries to account for the
forward purchase on 31 October 2016.
(e) Show the journal entries, assuming gross physical settlement on 31 October
2016.

ANSWER QUESTION 8

(a) Forward price at 1 May 2016. Journal entries

F o = S o (1+R-Y) T with simple compounding
= RM6 (1+0.08-0.04) 1/2 time to maturity in year
=RM6 x 1.0583
=RM6.35
No journal entries. Only memo 2 mil shares of Pujangga Bhd at RM6.35 per share
=RM12,700,000

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(b) Forward price at 30 June 2016. Gain/Loss. Journal entries
Fo = So (1+R-Y)T with simple compounding
= RM6.20(1+0.08-0.04)1/3 time to maturity in year
=RM6.20 x 1.0385 = RM6.44387
= RM6.44
Fair value of forward contract: Calculate the present value
(6.44-6.35)/(1.08)1/3 (2,000,000)
(0.09/1.0260) 2 mil = RM175,439
Forward contract is an asset in Financial Position
Dr Forward Pujangga shares-derivative asset RM175,439
Cr Gain on Forward (Profit/loss) RM175,439
To recognise gain on change in FV of forward contract

(c) Forward price at maturity, 31 Oct 2016. Gain/Loss. Journal entries

F o = S o (1+R-Y) T with simple compounding

= RM6.50(1+0.08-0.04) 0 time to maturity in year
=RM6.50 x 1= RM6.50
Fair value of forward contract: Calculate the present value
(6.50-6.35) x (2,000,000)
0.15x 2 mil = RM300,000
Forward contract is an asset in Financial Position

(d) Net settlement journal entries

Fair value contract at 31 Oct 2016 is RM300,000
Gain recognised on 30 June 2016 175,439
Balance to recognise 124,561

Dr Forward Pujangga shares-derivative asset RM124,561

Cr Gain on Forward (Profit/loss) RM124,561

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(e) Gross physical settlement

Dr Investment at FIFVPL(6.5 x 2 mil) 13 000 000

Cr Cash 12,700,000
Cr Forward Pujangga Shares 300,000
(derivative asset)