Ch 8. / KAP.12 - Financial Instruments Flashcards
What are the definitions? of the following:
Financial Asset
Financial Asset: Any asset that is:
- Cash
- Equity Instrument of another company (Investment shares)
-
A Contractual right to:
- Receive cash
- Another financial asset
- Exchange of financial asset/liability that is potentially favourable.
- A Contract that will/may be settled in the entity own instruments.
Examples:
Shares as an investment
Options contract
Trade Receivables (Technically financial instrument but is not treated by IFRS 9)
What are the definitions? of the following:
Financial Liability
Financial Liability: Any Liability that is:
-
A Contractual obligation:
- To deliver cash
- Another Financial asset
- Exchange of financial asset/liability that is potentially UNFAVOURABLE
- A contract under which an entity is obliged to issue a variable number of its own equity instruments.
Examples:
Trade Payables
Debenture loans payable
Redeemable preference shares
Forward contracts standing at a loss.
What are the definitions? of the following:
Equity Instrument
Compound Instrument
Derivatives
Equity Instrument:
A contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
Examples: Entity’s own shares or non-cumulative irredeemable preference shares
Compound Instrument:
Where a financial instrument contains some characteristics of equity and some of the financial liability. E.g Convertable Loan Notes
Derivatives:
Has 3 main characteristics:-
- Value changes in response to an underlying asset (Share price, forex rates, Interest rates).
- Requires no initial net investment, or an initial net investment that is smaller than required for other contracts with a similar expected market response.
- Settled in the future
Example. Contract for differences, forward contracts or options
8.1 Standards
Which standards affect financial instruments? and what is the reasoning for them?
3 key standards:-
- IAS 32: Financial Instruments: Presentation (& classification)
- IFRS 7: Financial Instruments: Disclosures
- IFRS 9: Financial Instruments (Measurements)
Reasoning:-
Many financial instruments were recorded inconsistently or even “Off-balance sheet” which meant they were not being recognised or disclosed.
The lack of comparability and omission of the information, Exposed the shareholders to significant risk.
What are the main classifications of a financial instrument?
- Financial Asset
- Financial Liability
- Equity Instrument
- Compound Instrument
How to classify a liability vs equity?
The problem many financial instrument contracts are in substance different from the legal form. So to help identify the difference between equity and financial liability is the golden rule:
- Fixed consideration + Fixed Number of shares deliverable = EQUITY
- Fixed consideration + Variable Number of shares or Redeemable = LIABILITY
Financial Liability instrument is it gives rise to a contractual obligation:
1) To deliver cash
2) Another financial asset that may be variable in an F.V amount.
Equity Instrument only gives evidence to the right to receive (not specifically contractually obliged to do so) an asset (Cash or PPE or dividends) from the residual value of an entity after deducting all of its liabilities. i.e retained earnings.
There is no legal requirement to deliver further cash or assets except in the case of liquidation.
Interest, dividends and loss and gains
All Payments in regards to financial liabilities are treated as a finance expense via P/L
All Dividends payments are paid/charged via the statement of changes in equity
Why is it important to understand the difference between a financial liability to equity from a Stakeholder perspective?
- Classification as a financial liability will result in increased gearing and reduced reported profit lower EPS (as distributions are classified as finance cost a P/L expense.
- Classification as equity will decrease gearing and have no effect on reported profit (as
distributions are charged to equity). Reduced share of dividends and dilution of ownership.
When can a financial asset and financial liability be offset?
The net amount (offset amount) may only be reported when the entity:
- - Has a legally enforceable right to set off the amounts
- - Intends either to settle on a net basis or to realise the asset and settle the liability simultaneously’ (IAS 32, para 42).
What is a Compound instrument?
How to account for Compound Instruments?
On recognition
Where a financial instrument contains some characteristics of equity and some of the financial liability then its separate components need to be classified separately
On Recognition
Dr - Cash/Asset - F.V of the consideration received on the agreement date.
Cr - Financial Liability - Carrying Amount of the Liability component:
- Present Value of liability discounted at the market rate for a similar liability without the equity component)
Cr - Equity - Residual amount (Balancing figure)
What are Treasury shares?
and How is it recognised in the accounts?
A treasury share is when a company buys back its own shares. which they may cancel or reissue at a later date.
Recognised as:
The amount paid presented as deducted/netted from equity. Any premiums or discount is recognised in reserves.
- Undecided if shares are to be cancelled or reissued, treasury shares held.
Dr Treasury shares = S.O.EQUITY
Cr. Cash
-
If they decide to cancel
- Dr - Ordinary Shares
- Dr - Expense
- Cr - Treasury shares
-
If they decide to issue
- Dr - Cash
- Cr - Treasury Shares
- Cr/Dr - share premium
How is a Financial Liability Recognised
and
How to choose measurement between FVTPL or Amoritised Cost?
A Financial Liability is recognised when an element/transaction meets the definition and should be initially recognised at the F.V.
The choice of the subsequent measurement and presentation of the Fin.L will dictate the financial liability initial measurement.
There are 2 main types, Financial Liabilities held at:
- Amortised cost
- Fair Value through Profit and loss (FVTPL)
How to choose?
- Amortised Costs
Most Fin. L will be held at A.C
Example: Loans and Borrowings held for the whole term and the company intends to repay capital and interest due on the loan.
- Fair Value through Profit and loss (FVTPL)
Except for Financial Liabilities which are:
- Held for Trading
- Out of money Derivatives (e.g.stock call options held at a loss, forward contracts held at a loss)
-
Fin. L that would normally be held as amortised, but the entity can make an irreversible election to hold at FVTPL, but any movement in F.V is split:
- change is due to own credit risk is via OCI
- remaining FV change via P/L
How to Initially Measure/Recognise and the Subsequent Measurement of Financial Liability via Amoritised Cost?
Initial Recognition
F.V + Transactions Costs
Face Value*
Less % Discount on issue
Less: Issue costs (e.g Legal fees)
= Initial Recognition of Liability
*Note: if the Loan was issued at 0% it should be discounted to P.V, using the market effective interest rate.
Note: Loan premiums are accounted for by using the effective rate of interest rather than the interest rate in the Loan Agreement. (example of substance over form)
Subsquent Measeurment
O/B: of Fin.Liability
Plus: Finance cost (Effective interest rate)
Less: Cash Payments/Coupon amounts)
C/B: of Fin.Liability
How to Initially Measure/Recognise and the Subsequent Measurement of Financial Liability via FVTPL?
Initial Recognition
F.V with transaction costs going to the P/L
- *Face Value –)** = The net cash proceeds.
- *= Initial Recognition of Liability**
*Note: Cash flows discounted to P.V if interest fee loan
Note: Loan premiums are accounted for by using the discounted cash flows.
Subsquent Measeurment
- The liability is remeasured to F.V <strong>(this is done by using the interest rate on the reporting date) </strong>
O/B: of Fin.Liability
Plus: Finance cost (Effective interest rate)
Less: Cash Payments/Coupon amounts)
Balance: of Fin.Liability
*Bal Fig. Gain or loss in F.V charged to the P/L**
C/B of Fin Liability = P.V of remaining Cash flows (discounted using market interest rates on the reporting date)
*Note- If the Fin.Liability is FVTPL because of an accounting mismatch the % change in the interest rate due to own credit risk is split:
Gain or loss on remeasurement due to own credit risk is split:
- - Own Credit Risk —) OCI
- - Remainder to P/L
How are Financial Guarantee contracts given by the company are accounted for?
Financial Guarantee - Guarantee given by the entity to cover a debt is a liability.
Initial recognition is at F.V
Cr - Liability
Dr- P/L
Subsequently, remeasure it at the higher of:
- the amount determined in accordance with IAS 37 (provisions).
- amount initially recognised less the cumulative amortisation (when appropriate).
Numbers similar to amortised cost when there’s no change in risk
If there is a change in risk. resulting in increased liability.
1st Calculate the normal level of amortisation
But the increased liability is then calculated by taking the
C/B Liability after amortisation
Bal Fig- the cost of an increase in financial guarantee risk Cr- Liability/ Dr- P/L
C/B Remeasurement of Liability
When are financial assets Recognised?
How should they be classified?
and
How does the classification affect the measurement basis?
IFRS 9 says that an entity should recognise a financial asset:
- ‘when, and only when, the entity becomes a party to the contractual provisions of the instrument’
Classification of Financial asset?
The Cash Flow Test <em>is used to identify the type of financial asset:-</em>
Do contractual terms of the financial asset give rise to, specified dates to cash flows that are Solely Payments of Principal and Interest S.P.P.I on the principal outstanding.?
Simply - Are the ONLY cashflows coming in capital and interest?
- Yes - Debt Instrument
- No - Equity Instrument
The Business Model Test:- Is used to identify the measurement basis
- Hold to collect
- Hold to collect and sell
- Other or unsure
How to Measure a Financial asset that is an Equity Instrument?
Business Model test
FVTOCI -
- The equity instrument must not be held for trading, and
- Irrevocable choice for this designation upon initial recognition of the asset.
- The equity instrument must not be held for trading, and
FVTPL -
- The default expectation is that equity instruments will have the designation of fair value through profit or loss.
FVTPL Measurement
Initial Measurement:
- at F.V (Most likely the purchase price)
- Transactions costs are expensed to P/L
Subsequent Measurement:
- Asset is revalued to fair value
- with the gain or loss recorded P/L
FVTOCI Measurement
Initial Measurement:
- at F.V (Most likely the purchase price)
- + Plus Transaction Costs (capitalised)
Subsequent Measurement:
At each year-end or before disposal of an asset:
- The asset is remeasured to F.V
- Gains or losses recognised in the OCI
How are Investments into debt Instruments (Financial assets) accounted for?
The Business Model Test is carried out to see how they should be measured.
Hold to collect - To collect contractual cashflow SPPI —) Amortised Cost
E.g Investment into a Debenture or trade receivables.
Hold to collect and sell - To collect contractual cashflow and Sell —) OCI
E.g Government treasury bonds
Other/All other business models - unsure if planning to trade, or anything else —) FVTPL
How to measure a Debt Instrument?
Held to collect - To collect contractual cashflow SPPI —) Amortised Cost
Investments in debt that are measured at amortised cost:
- *- Initially recognised @ at F.V plus Transaction costs.
- Interest income is calculated using the effective rate of interest.**