In this lesson, you’re expected to learn about:
– derivatives, foreign currencies, and hedging
– share buybacks and corporation tax
– share-based payments and earnings per share
What are Financial Instruments?
Financial instruments are a broad category made up of financial assets and financial liabilities. An example of a financial asset is investment made in other companies’ shares while examples of financial liabilities are bank and corporate debt.
Financial Assets & Liabilities
A financial asset is any contract between you and a third party that is an asset in your books and is either a financial liability or an equity instrument in the other party’s books. Financial assets include trade receivables, investments in another company’s shares, loans receivable, and derivative contracts that are favorable to you.
A financial liability is any contract between you and another party that is a liability in your books and an asset in their books. Financial liabilities include trade payables, loans payable, and derivative contracts that are unfavorable to you.
Derivative contracts are contracts between two parties whereby one party gains and the other loses depending on what happens to some underlying variable. The variable could be, for example, a particular interest rate, commodity price, share price or bond price.
Some of the most common derivatives are:
· Interest Rate Swaps
– agreement to buy or sell a specified quantity of something on a specified date at a specified price.
– when the settlement date arrives, it is actually delivered or the two parties agree a cash amount to settle the contract.
– e.g. agreement to sell 100 tons of wheat on a particular date at a price of 150 per ton.
Similar to forwards except that:
– they are standardized contracts.
– they are traded in large volumes on exchanges around the world.
– consequently always settled by cash rather than delivery of the underlying item.
– one party pays the other an amount of money now (the premium) for the right (but not obligation) to buy a quantity of something during a specified time period at a specified price.
– can be settled by delivery or by a cash payment.
– many are standardized and traded on exchanges while others are custom-written between the two.
– e.g. the right to buy shares in a listed company at a price of $1.50 at any time in the next three months.
– agreement to exchange one set of interest payments on a loan for another set of interest payments.
– e.g. the bank agrees to give you six-monthly interest payments on a notional loan of $1 million at the lending rate + 2% in return for you giving them the six-monthly interest payments on a notional $1 million based on a fixed interest rate of 3%.
When utilized appropriately, these derivatives are valuable to businesses because they can give the business certainty about the future.
For example, say you know that in the course of the next financial year, you’re going to make sales in euros worth 10 million. You might be worried about the exchange rate moving against you and hurting your profits. So you can enter into a forward contract today that fixes the price in pounds that you’ll get in three, six, nine or twelve months’ time. Thus, you’re guaranteed some certainty.
A company has to classify all its financial instruments into various categories and then account for them in accordance with the rules for that category. There are three ways that they can be treated:
1) The instrument is carried at fair value on the balance sheet and any change since the last balance sheet affects retained profit through P&L.
2) The instrument is carried at fair value on the balance sheet and any change since the last balance sheet affects retained profit through OCI.
3) The instrument is carried at amortized cost.
· Investments bought with the intention of trading them: at fair value
· Trade receivables and payables: at amortized cost
· Loans made: at amortized cost
· Derivatives: at fair value
Many major companies have dealings abroad, which involve them in foreign currencies. There are two main ways in which a company can be affected by foreign currencies:
1) The company trades with third parties, making transactions that are denominated in foreign currencies.
2) The company owns all or part of a business that is based abroad and which keeps its accounts in a foreign currency.
Suppose you have a company based in France and which therefore uses the euro as its main currency. This company carries out some transactions that are denominated in US$. Also, the company is owned by a UK company (parent), which reports to its shareholders in GBP.
In this case:
· The French company’s functional currency would be the euro.
· The US$ would be a foreign currency to the company.
· GBP would be the presentation currency of the UK parent.
Functional currency: the currency of the primary economic environment in which the entity operates.
Presentation currency: the currency in which financial statements are presented.
To consolidate the French company’s accounts into the accounts of its UK parent:
1) Convert all foreign currency transactions into the functional currency.
2) Convert the P&L, balance sheet and cash flows from the functional currency into the parent’s presentation currency.
Subject to different rules, companies are allowed to buy their own shares back from shareholders.
Reasons for share buybacks:
– the company thinks its share are undervalued in the marketplace.
– it is an alternative to paying a dividend.
– the company has promised shares to its employees as part of an incentive scheme.
Since a buyback is an investment in listed shares, you would decrease cash and increase investments.
However, that’s not exactly what’s happening. Instead we treat it as if the company was doing the opposite of issuing shares. So we reduce shareholders’ equity. In effect, we decrease cash and decrease treasury share reserve.
Treasury share reserve (also known as own share reserve) is an item under shareholders’ equity on the claims side that decreases shareholders’ equity when shares are bought back. Thus, it will always have a negative figure.
– the company may hold on to the shares until a reason to reissue them arises.
– most common application is to re-issue them to employees who have earned the right to shares under an incentive scheme.
– alternatively, the company may cancel the shares entirely.
– companies prefer to keep shares they’ve bought back as there is less cost and paperwork associated with reissuing them than there is with issuing new shares.
Equity-settled share-based payments
As part of their remuneration package, employees of companies are often promised free shares in their company if they are still with the company on a stated date – this is known as the vesting date.
The date between the date on which the shares are promised and the vesting date is the vesting period. If the performance conditions have been met and the vesting date has passed, the shares are described as vested, i.e. the employee is unconditionally entitled to the shares.
These options give the employee the right, after an agreed vesting date has passed and sometimes subject to performance targets being met, to make the company sell them shares at a price agreed at the time the options are issued to the employee – this is known as the exercise price.
– Because employees usually lose their options or shares if they leave a company, these schemes also tend to encourage employees to stay with a company.
These are bonuses paid in cash where the cash amount to be paid is determined by reference to the company’s share price. E.g. an employee bonus that is determined by the rise in the company’s share price between two dates.
As before, you need to estimate the fair value of the potential bonus and then can do the accounting, which will be different since the obligation is going to be paid in cash.
Another difference from equity-settled schemes is that you have to do the fair value estimate for every balance sheet date.
The accounting process works as follows:
1) Figure out the fair value of the promise to the employee without taking account of any performance conditions
2) Estimate how many of the promised shares or options are likely to vest.
3) You now have an estimated cost to the company of the share-based payment. Allocate that cost across the whole vesting period and thus determine how much belongs in the period you are accounting for.
– issuing brand new shares to the employee.
– transferring existing shares from the treasury share reserve to the employee.
1) Basic earnings per share
– this is simply the profit for the year divided by the average (time-weighted) number of ordinary shares in issue during the year.
– adjustments may need to be made to both the earning figure and the number of shares.
– listed companies are required to calculate and present diluted earnings per share.
– these companies have one or more arrangements that might require them to issue shares which means that the profits of the company have to be shared out among more shares. So the actual issued shares are ‘diluted’.
– these arrangements can affect both the profit for the year and/or the number of shares used in the calculation of diluted EPS.
– diluted EPS is always lower than basic EPS.
– companies often present an adjusted profit figure and adjusted earnings per share.
– this is usually higher than the unadjusted figure and/or shows better growth from the previous year.
– accounting for enterprise transactions is straightforward however that doesn’t make them less important
– earnings per share is the widely used measure for valuing listed companies.