Financial Instruments Report for ARB Corporation Limited

Question

Instructions for the report
AASB 9 (and IFRS 9) Financial Instruments was initially released in December 2014, but it will become effective from financial reporting periods beginning on or after January 1, 2018. This will bring fundamental change to financial instrument accounting when it replaces the existing accounting standard: AASB 139 (IAS 139) Financial Instruments: Recognition and Measurement. Entities reporting financial instruments will need to make several decisions and choices in relation to the transition to the new standard. Many businesses, especially banks and other financial institutions, will be affected by the implementation of the new standard. You can find more information regarding some changes made by the new accounting standard in 2018 and industry impact for various entities from the following links:
https://www.pwc.com.au/ifrs/new-standard-financial-instruments.html
https://nexia.com.au/news/accounting/aasb-9-financial-instruments-understanding-the-basics.

This task requires you to prepare a report to evaluate and comment on information regarding financial instruments provided in the annual report of a company listed on the Australian Stock Exchange (ASX). Your comments or evaluation should comply with the requirements of relevant Australian accounting standards (AASBs).

Part A

1. Discuss the recognition for financial instruments including financial asset, financial liabilities and equity instruments according to relevant AASBs.
2. Discuss the measurement of finical instruments according to related to relevant AASBs.
3. Identify different types of financial instruments available in the chosen company. Provide at least one example of each type of financial instrument available in the chosen company and specify recognition and measurement of that financial instrument.

Part B
From the perspective of the investors, discuss the potential impact of the adoption of new AASB 9 on assets, liabilities, financial performance and one of selected financial ratios (such as debt/equity ratio) of the chosen company.

You should include the examples that you have identified in part A3) in your discussion.

Answer

Executive Summary: The increased globalization and cross-border business relations have made it mandatory for the financial reports of different countries to communicate a similar language. This is achieved through the convergence to IFRS which makes interpretation of financial statements easier and more apt to suit the business requirements. With the effective implementation of the IFRS, entities could have significant changes in their financial reporting. Its implementation is not just restricted to equity instruments or such other long terms loans and receivables but can extend to a few items on the profit and loss account also. This report discusses the financial instruments concepts that are in tune with the IFRS with practical examples from the annual report of a listed company.

Part A
Financial instrument recognition: IFRS 9 specifies an entity’s classification and its measurement. Further it relates to financial asset or financial liability and other contracts to buy or sell non-financial items. IFRS 9 allows an entity to account for an asset or liability of financial type only when it has become a party to the contract in accordance with the contractual provisions affected by the relevant instruments. At the prior stage, the financial asset recognition and financial liability is made at the fair value with an addition of the costs of transaction that are incurred to acquire the asset or issue the liability. Hence, it is imperative that the recognition should happen at the time when the entity links to obligations of contractual nature, unlike the other IFRS where the emphasis is laid on the future economic benefits (Horton & Serafeim, 2010).

Derecognition of financial asset or removal happens from the financial statements when the expiry happens from that of contractual rights or cash flows or when there is a transfer of the entity and such a transfer leads to the qualification for derecognition (Deegan, 2005).

Derecognition of a financial liability happens when it gets extinguished or in other words, its obligations are discharged or canceled or expires.

1. Measurement of financial instruments according to the relevant AASBs.
Financial Assets: Every entity is expected to follow a business model to manage its financial assets and the cash flows of contractual nature arising and flowing from the assets. Based on this business model, the financial asset recognition is made according to the following criteria:

a) Amortized Cost: The financial asset recognition is done at the cost of amortization only if both the conditions listed below are met:

• The asset is held by the entity for the purpose of collection of cash flows of contractual nature and the entity aim is to hold the assets for business purposes.
• Due to the possession of the financial asset, cash flow arises that are solely payments of principal and interest amounts outstanding on the assets (Landsman et. al, 2011)

b) FV from a different comprehensive income:In a business model when the aim of holding financial assets is both for the generation of cash flows and for selling financial assets, the classification happens through fair value through income of comprehensive nature (IFRS, 2016).

IFRS 9 also provides guidance on whether the business model is meant for managing the assets or for the contractual cash flows or collection of both.

c) FV through P/L: If the recognition of financial assets is not done in any of the above two methods, then the financial assets are recognized at FV through P/L.

IFRS 9 states that when the business model changes, then a reclassification of all the financial assets has to be done.

Financial Liabilities: Financial liabilities are ascertained in the following ways:

a) At FV through PL: The financial liabilities that are not ascertained at amortized cost fall in this category like derivative instruments, other financial liabilities for trading and such liabilities that the entity has specifically classified to be evaluated at the concept (Lai et. al, 2013).

b) At cost of Amortization: All financial liabilities are evaluated at amortized cost leaving those measured at fair value through profit and loss (Maria, 2016).

Equity Instruments: IFRS 9 states that the measurement of equity instruments has to be done at FV. The changes in the equity instruments have to be recognized in the P/L account. The exception being for the equity instruments that the entity has opted to present the variances in the comprehensive income.

IFRS 9 provides the option to designate the instrument of equity at FV through other comprehensive income and this option can opt at the initial time. It is an irrevocable option. This classification will result in all the gains and losses being presented under the other comprehensive income except the dividend income which is seen in the income statement.

IFRS 9 even projects way on when the cost might is feasible for FV and when should not be used for fair value.

Thus these are the measurement criteria laid down in IFRS 9.

2. Different types of financial instruments available in ARB Corporation Limited
The company selected for discussion and analysis is ARB Corporation Limited. It deals with the manufacture, design, and other engineering matter related to motor vehicles.

The performance of the company has been pretty good and in a growing phase. The revenue, profits, and dividends have all seen a steady increase. It needs to be noted that the companies demand for the products are healthy. It is thus well poised for a long-term business growth (ARB Corporation, 2017).

The financial statements notes contain the details and explanations about the financial assets, financial liabilities, and equity. The below has been extracted from the same. The derivatives that are designated as effective hedging instruments are forward exchange contracts and these are carried at fair values (ARB Corporation, 2017).

a) Derivative Financial Instruments are classified under Current Assets.
Example – Loans & Receivables

Recognition – These financial assets are recognized when the company enters into a contract and the other party is under an obligation and also bound by the performance of the contact.

Recognition – These financial assets are recognized when the company enters into a contract and the other party is under an obligation and also bound by the performance of the contact.

b) Derivative financial instruments are classified under current liabilities.

Recognition – On similar lines as a financial asset, financial liabilities are recognized upon entering into contractual obligations where both the parties agree to undertake their obligations (Hanlon et. al, 2014).

Measurement – The financial liabilities mentioned above from third parties are measured at the amortized cost since these are fixed sums of liabilities and do not alter with time (ARB Corporation, 2017). Hence fair value measurement is not adopted for these liabilities. The amortized cost is checked for on the reporting date and the amount of liability outstanding is disclosed in the statement.

c) Consolidated statement of changes in equity presents the movements and profit or loss made by the company. Retained Earnings recognize and take into account the movements in FV of cash flow hedges, net of tax (Goodwin, 2008).

Example – Cash Flow Hedges

Recognition – There are derivatives of specific nature that are allotted to be instruments of hedging and such derivatives are recognized as Cash flow hedges. For classification under this category of cash flow hedge, the items that generate the cash flows should be realistic (Hanlon et. al, 2014).

Measurement – The changes in the FV of the derivatives on the reporting date are recognized under the equity account in a reserve of hedging of cash flow. The profit or loss arising is passed on to the Income Statement during the same period when such transactions occur, thus mitigating the chances of fluctuations of exchange rate that would have occurred when hedging is not present (Goodwin, 2008).

Part B
As the adoption of IFRS is at a phased stage, there are a few standards that are currently in force and being adopted by the company whereas the other IFRS are not currently to be mandatorily followed but available for early adoption by the company (Byard, 2011).

As IFRS 9 simplifies the approach towards the financial assets and liabilities classification and measurement in comparison to AASB 139, there could be a change in the recognition, classification, and measurement of financial assets when the standard is adopted (ARB Corporation, 2017). The change is due to the fact that the standard allows the provision of the fair value of gains or losses in income of comprehensive nature that are not held for trading. This would be the impact of the change in the financial assets recognition and measurement (Byard et. al, 2011).

As per the needs of IFRS 9, the financial liabilities accounting that are provided at FV through PL will only be influenced. Hence no influence will be there on the accounting for entity’s for financial liabilities (ARB Corporation, 2017).

With reference to the cash flow hedge, the requirements of IFRS 9 state that a new model has to be developed which is deeply aligned with the risk management and application will be easy. The implementation cost will be reduced but the model requires extended disclosures. Thus the impact of this new hedge accounting model is yet to be assessed by the company as it is applicable from 1 January 2018.

Out of the items discussed above, financial assets like loans and receivables will not be influenced by IFRS 9. Financial liabilities like trade payables, other creditors and liabilities will also not undergo a significant change in the adoption of IFRS 9 (ARB Corporation, 2017).

The debt-equity ratio of the company is currently Nil as the company is not having borrowings as per the statement of financial position.

Hence another ratio is discussed which is a return on equity which is currently 18.83. Upon adoption of IFRS 9, it is possible that due to the recognition of the financial assets and liabilities which are to be concerned at FV through P/L account, the net profits of the company might increase or decrease (ARB Corporation, 2017). This increase or decrease is largely dependent upon the measurement of fair value which is a result of the overall market conditions on the reporting date. Hence the ratio will accordingly increase or decrease.

Conclusion
The significance of IFRS 9 is thus seen in terms of recognition and measurement of financial assets, financial liabilities, and equity. The accounting and disclosure for cash flow hedge is the only item that will require more efforts in terms of the development of a model and extended disclosures. From the investor perspective, it would be evident that the adoption of IFRS 9 will bring the financial statements closer to the current market scenario. Most of the items that were being shown at the current or historical cost figures will now be disclosed at fair values and hence the profitability of the company can either increase or decrease. It will also not facilitate one on one comparison with the prior year figures due to the changed recognition and measurement criteria.

References
ARB Corporation. (2017). ARB Corporation Annual report and accounts 2017. Retrieved from: http://www.annualreports.com/Company/ARB-Corporation-Limited [Accessed 25 May 2018]

Byard, D, Li, Y, & Yu, Y. (2011). The effect of mandatory IFRS adoption on financial analysts’ information environment. Journal of Accounting Research, 49(1), 69-96.

Deegan, C. (2005). Australian Financial Accounting. McGraw Hill, Sydney.

Goodwin, J, Ahmed, K & Heaney, R. (2008). The Effects of International Financial Reporting Standards on the Accounts and Accounting Quality of Australian Firms: A Retrospective Study. Journal of Contemporary Accounting & Economics, 4(2), 89-119.

Goodwin, J. & Ahmed, K. (2006). The Impact of International Financial Reporting Standards: Does Size Matter?. Managerial Auditing Journal, 21(5), .460- 475.

Hanlon, D., F. Navissi & G. Soepriyanto (2014). The value relevance of deferred tax attributed to asset revaluations. Journal of Contemporary Accounting & Economics, 10(2): 87-99.

Horton, J. & Serafeim, G. (2010). Market reaction to and valuation of IFRS reconciliation adjustments: first evidence from the UK. Review of Accounting Studies, 15(4): 725-751.

IFRS. (2016). IFRS Application around the world jurisdictional profile. Retrieved from: http://www.ifrs.org/Use-around-the-world/Documents/Jurisdiction-profiles/Australia-IFRS-Profile.pdf [Accessed 25 May 2018]

Lai, C., Lu, M & Shan, Y. (2013).Has Australian financial reporting become more conservative over time?. Accounting & Finance, 53, 731-761.

Landsman, W. R, Maydew, E. L & Thornock, J. R. (2011). The information content of annual earnings announcements and mandatory adoption of IFRS. Journal of Accounting and Economics, 53(2), 34-54.

Maria, W. (2016). The Big Consequences of IFRS: How and When Does the Adoption of IFRS Benefit Global Accounting Firms?. The Accounting Review, 91(4), 1257-1283