Title: – Financial Instrument
Author: – Kalpana Ghongade
Roll No.:- 0222016
Literature Review:-
Financial Instruments in the Banking Industry
Günther Gebhardt et al (2004) states that in terms of money and capital, the commercial bank acts as an intermediary between borrowers and lenders, and for the buy and sell of bonds, shares, and derivative products, the investment bank advises and executes orders for its customers. Risk management is organised by Universal Bank these risks are managed in specialised departments. The banking book and the trading book are a set of two portfolios that describe the model bank. The two banking strategies analysed are that the bank fully hedges against any movement in interest rates and that the bank hedges against only partially changing interest rates. Financial assets and liabilities are measured on an amortised cost basis in the all-banking book. Identical financial instruments are reported differently depending on their allocation either to the trading book or to the banking book, which is the first anomaly of these measurement rules. (Gebhardt et al 2004)
Financial Engineering
Vivek Shah and Padma Srinivasan (2010) states that the design, development, and implementation of innovative financial instruments and processes and the formulation of creative solutions to problems in finance are involved in financial engineering. Increasing cost efficiency by reducing transaction costs, financial innovation plays an important role. During the financial crisis, to handle all the regulatory reform, financial engineering may provide the appropriate expertise. Intended to split the risk and return components of financial instruments and offer the combination that is best suited to an investor’s risk-return profile, this is basically financial engineering. Financial engineering’s presence spans across areas like the design of innovative financial instruments, financing mergers and acquisitions (M&A) deals, corporate restructuring, derivative trading strategies, etc.( Shah and Srinivasan 2010 )
Derivative financial instruments
Bullen Halsey G. and Laura Porterfield J. (1994) states that Forwards and Options there are two groups of derivative financial instruments. One party to buy and the other to sell a specific asset at a future date for a fixed price; this is an obligation of a forward contract. The holder must pay a premium to the issuer at the inception of the contract in exchange for the ability to benefit from favorable movements in the price of the underlying asset, rate, or index with no exposure to risk from unfavorable price movements other than the loss of the premium paid, which is generally required in option contracts. A use for derivative financial instruments is managing exposures arising from a financial institution’s asset and liability mix. This is the nature of derivative financial instruments. (Halsey and Porterfield 1994)
The characteristics of financial instruments
Neil Fargher et al (2019) states that in the financial statements the classification, measurement, and presentation of items that are affected by Distinguishing between the elements of liabilities and equity is a fundamental accounting issue. Compound financial instruments have the characteristics of liabilities and equity. The liquidity or solvency approach and the ownership or residual (valuation) approach are two characteristics of the financial instrument. In the assets of an entity after deducting all of its liabilities, the equity instrument is any contract that evidences a residual interest. Presents challenges for standard setters and practitioners in accounting for compound financial instruments, that is, those with characteristics of both debt and equity. (Fargher et al 2019)
Allocation of Convertible Debt Proceeds
King Thomas E. and Alan Ortegren K (1990) states that the most important issue facing the accounting profession today is financial reporting issues related to company financing. Distinguishing between liabilities and equity is the FASB’s financial instruments project. The straight-debt value of convertible securities is an allocation of convertible bond issue amounts that should be possible by estimating. Make the kinds of appraisals necessary for an accounting allocation of the convertible bond issuance price on a regular basis, as indicated by conversations with experienced bond traders and underwriters. Between debt and equity, the proceeds from the issuance of synthetic convertibles are appropriately allocated. The same debt features independently can achieve a consensus as to the value of the debt that the different finance professionals are assessing. ( Thomas E. and Ortegren 1990)
Recognition and Measurement of Financial Instruments
Jerry Weygandt J. and Mary Barth A (1993) states that the American Accounting Association’s Financial Accounting Standards Committee is tasked with responding to standard-setters’ requests for opinions on matters pertaining to financial reporting. The Committee responded to the FASB Discussion Memorandum on “Recognition and Measurement of Financial Instruments” as part of its duties. The committee urges the board to adopt fair value estimates because it thinks they will give users of financial statements more pertinent information. The Committee thinks market values should be calculated as the present value of anticipated cash flow discounts at a suitable discount rate for receivables and payables for which quoted market prices are not easily accessible. According to the Committee, financial option-related assets and liabilities should be valued at fair value going forward. (Weygandt and Barth 1993)
Accounting for Impairment of Financial Instruments
Noor Hashim et al (2016) states that the recognition of a credit loss must be accompanied by tangible evidence that a loss has been sustained, according to the incurred loss model, which is currently incorporated into International Financial Reporting Standards (IFRS). In order to improve the measurement and reporting of financial instruments, the Board and the FASB are committed to cooperating in the development of a complete standard. The various sets of ideas and final standards for expected-loss methods of accounting for credit-loss impairment that have emerged independently or together are examined in this study. Classification and Measurement, Impairment, and Hedge Accounting were all topics included in the FASB exposure draught for the Financial Instruments project. (Hashim et al 2016)
Representations of Financial Statements
Abdel Khalik and A. Rashad (2019) states that hedging the volatility of fair values and hedging the volatility of future cash flow are the two relevant categories in this research. In order for a financial report to be meaningful, the financial information must accurately reflect the phenomena it claims to describe as well as any relevant phenomena. Financial derivatives are bilateral contracts without underlying principles that derive their values and risks from variations in prices or other particular indices that result in rights (assets) and obligations (liabilities) for the two parties to the contract. Derivatives’ assets and liabilities must be evaluated at fair values in accordance with the basic standard, and any changes to fair values must be recorded on the income statement. The location of reported items on the income statement and balance sheet is changed by the Hypothetical Derivatives Method by creating relationships that don’t exist. ( Khalik and Rashad 2019)
Financial literacy
Leora Klapper and Annamaria Lusardi (2020) state that financial resilience and taking on too much debt can both be improved with greater financial awareness. Reducing risk exposure to company and personal assets through diversification is important. We make an effort to investigate the relationship between risk diversification and market stability, which is essential for people’s and nations’ ability to make informed investment decisions. High levels of borrowing make families more susceptible to economic and financial market shocks and may reduce their ability to repay loans, just like in the non-financial business sector. Although participating in the financial markets as a credit user may boost an individual’s financial capacity, a lack of understanding of risk and interest compounding can cause instability in the market. (Klapper and Lusardi 2020)
Functional Fixation
Fatima Alali et al (2018) states that Users of financial statements according to the FFH (functional fixation hypothesis), are fascinated by reported earnings figures, particularly when those figures are obvious and recognised in the income statement rather than hidden and revealed in the financial statements’ notes. The EMH (efficient market hypothesis) contends that users are effective and that the market would understand and take into account any disclosure, regardless of where it was made. The process of formally documenting or incorporating an item into an entity’s financial accounts as an asset, liability, revenue, expense, or something similar is known as recognition. If there is an active market, a quoted price from that market is used to determine fair value. The functional fixation in accounting is caused by the ultimate profit figure. (Alali et al 2018)
Conclusion:-
Universal Bank is a commercial and investment bank that manages risks in specialised departments. It has two portfolios, the banking book and the trading book, and measures financial assets and liabilities on an amortised cost basis. Financial engineering is the design, development, implementation, and formulation of innovative financial instruments and processes to increase cost efficiency and reduce transaction costs. Financial derivatives are bilateral contracts that derive their values and risks from variations in prices or other indices. Financial resilience and taking on too much debt can be improved with greater financial awareness, risk diversification, and understanding of risk and interest compounding. Derivatives’ assets and liabilities must be evaluated at fair values, and any changes to fair values must be recorded on the income statement.
Reference:-
ABDEL, Khalik, A. Rashad (2019) Failing Faithful Representations of Financial Statements: Issues in Reporting Financial Instruments. Abacus, [s. l.], v. 55, n. 4, p. 676–708, 2019. DOI 10.1111/abac.12176. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=bf229f6f-3b0b-3b2a-91e6-0182ac8a03f1. Acesso em: 12 maio. 2023.
ALALI, FATIMA;SIREGAR, DONA;ANANDARAJAN, ASOKAN (2018). A Test of the Functional Fixation Hypothesis Using Derivative Financial Instruments. Quarterly Journal of Finance & Accounting, [s. l.], v. 56, n. 1/2, p. 1–28, 2018. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=01e3710f-92e6-3a94-8b5e-67472c05237d. Acesso em: 12 maio. 2023.
Bullen, Halsey G.;Porterfiled, Laura J (1994) Derivative financial instruments: Time for better disclosure. CPA Journal, [s. l.], v. 64, n. 7, p. 18, 1994. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=febde50e-eb38-3323-b7a9-43d5a1a2c99a. Acesso em: 12 maio. 2023.
Fargher, Neil;Sidhu, Baljit K.;Tarca, Ann;van Zyl, Warrick (2019). Accounting for financial instruments with characteristics of debt and equity: finding a way forward. Accounting & Finance, [s. l.], v. 59, n. 1, p. 7–58, 2019. DOI 10.1111/acfi.12280. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=46438627-fd79-3fbb-afa5-69e5673f9b9e. Acesso em: 12 maio. 2023.
GEBHARDT, Günther.; REICHARDT, Rolf.; WITTENBRINK, Carsten (2004) Accounting for financial instruments in the banking industry: conclusions from a simulation model. European Accounting Review, [s. l.], v. 13, n. 2, p. 341–371, 2004. DOI 10.1080/0963818042000204733a. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=53d6ccaf-302c-3533-b491-8f239226111f. Acesso em: 12 maio. 2023.
Hashim, Noor;Li, Weijia;O’Hanlon, John (2016). Expected-loss-based Accounting for Impairment of Financial Instruments: The FASB and IASB Proposals 2009–2016. Accounting in Europe, [s. l.], v. 13, n. 2, p. 229–267, 2016. DOI 10.1080/17449480.2016.1210179. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=58c22322-e46a-35ee-b2a9-2da7a1c0ae83. Acesso em: 12 maio. 2023.
King, Thomas E.;Ortegren, Alan K.(1990) A Reassessment of the Allocation of Convertible Debt Proceeds and the Implications for Other Hybrid Financial Instruments. Accounting Horizons, [s. l.], v. 4, n. 3, p. 10–19, 1990. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=b6d463dc-c052-3061-8b68-f65ca33bb8c8. Acesso em: 12 maio. 2023.
Klapper, Leora;Lusardi, Annamaria (2020) Financial literacy and financial resilience: Evidence from around the world. Financial Management (Wiley-Blackwell), [s. l.], v. 49, n. 3, p. 589–614, 2020. DOI 10.1111/fima.12283. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=b29e3327-590e-3df1-bc20-98911f75f03b. Acesso em: 12 maio. 2023.
Shah Vivek, Srinivasan Padma (2010),Financial Engineering and Innovation as Risk Management Tools: The Case of Indian Companies During Global Financial Crisis. IUP Journal of Risk & Insurance, [s. l.], v. 7, n. 1/2, p. 50–66, 2010. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=a941736e-4e43-371a-91a0-f307c09ee17f. Acesso em: 12 maio. 2023.
Weygandt, Jerry J.;Barth, Mary A (1993). Response to the FASB discussion memorandum `Recognition and Measurement of Financial Instruments’. Accounting Horizons, [s. l.], v. 7, n. 3, p. 95–104, 1993. Disponível em: https://discovery.ebsco.com/linkprocessor/plink?id=a81f6f0a-4bc9-3fa8-a850-f4c7b6f7d10b. Acesso em: 12 maio. 2023.