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Quantifying the impact of financial instruments enables management to better navigate through uncertainty

Adrian Cheow Jan 24, 2024

Why it is important to fully understand the implications of specific clauses in financial contracts on the company's cost of financing, gearing ratio, profit and loss, and various other aspects.
 

Understanding Financial Instruments

  • Financial instruments are contracts that give rise to both a financial asset of one entity and a financial liability or equity of another entity.
  • Financial instruments can have significant impacts on the financial position and performance of an entity, as well as the risks the entity is exposed to, and how the entity manages them.
  • Financial instruments can also be subject to impairment, hedge accounting and derecognition, which can affect the recognition and measurement of gains and losses in the financial statements.
  • Financial instruments require extensive disclosures in the financial statements, such as their carrying amounts, fair values, risk exposures, credit quality, and hedging relationships.

Considerations In Financial Contracts Management

  • A comprehensive understanding of the implications of non-standard clauses is essential when dealing with financial contracts.
  • Due to time constraints and busy schedules, management might not have time to fully assess the impact of certain clauses on the financial statements and financial reporting.
  • Management sometimes misunderstand or are misled by a financial terminology or phrasing.
  • Lawyers play a role in facilitating the negotiation, but their main focus is on drafting and legalizing the contract.
  • A professional valuer can provide assistance in negotiating, valuing, accounting for, and continuously monitoring the financial impacts of various financial instruments.

As a professional in finance, you may ask certain questions that will require case-by-case analysis to answer:

  • How often is valuation required?
  • Can I conduct fair value assessment on my own or do I need to engage a valuer?
  • How do I conduct fair value assessment on a particular instrument?
  • What is the overall actual cost of financing?
  • Will subsequent measurements be complex?
  • How will the fair value change affect my profit and loss?
  • Which financial reporting standards should I comply with?
  • Can I choose among amortised cost, FVTPL* and FVOCI**?
  • How much will my gearing ratio increase by?

* Fair value through profit or loss 
** Fair value through other comprehensive income

A Quick Guide To Evaluation

You can use the following map to assess whether your loan contract needs multiple fair value reporting.

A Real-Life Example

  • A listed company entered a convertible bond agreement for financing purposes. Its management thought it only needed to conduct fair value assessment on the bond once, on the inception date as a compound instrument.
  • But its auditor identified a clause that will direct the convertible bond to be converted into a variable number of shares. Eventually, the convertible bond was classified as a hybrid liability that required fair value assessment at each interim and financial year end date subsequently.
  • The management was surprised with the extra financial reporting efforts and reporting costs. "This clause is something nice to have, but not necessary," said the CFO. He had expected this scenario to be highly unlikely, so he did not foresee this impact on reporting.

As we conclude, remember that engaging valuers before and after signing a financial contract ensures that you fully understand the impact on your company's financial standing. For further insights or to discuss your specific financial scenario, connect with us today.

Quantifying the impact of financial instruments enables management to better navigate through uncertainty

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Adrian Cheow
Executive Director & Practice Leader | CFA, FCCA

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