CH8 financial instruments Flashcards
Definition: financial instrument
Any CONTRACT that gives rise to both a financial asset (DR) of one entity and a financial liability or equity (CR) of another entity.
Financial instruments fall into three categories. What are they?
- Financial assets (derived from a contract) (DR) eg:
- cash
- equity instrument of another equity (shares in another company)
- contractual right to receive cash or another financial right from another entity (eg TRs, loans receivable) - Financial liability (CR): contractual obligation to deliver cash or another financial asset to another entity eg:
- TPs, debenture loans/bond/loan note (another company/bank has lent you money)
- redeemable pref shares - Equity instrument (CR): contract that evidences a residual interest in the assets of another entity after DEDUCTING all of its liabilities eg.
- a company’s OWN ordinary shares
- irredeemable pref shares
What are NOT financial assets? Why?
- PPE
- Intangibles
- Inventories
They do not arise from a contract. Their value arises from their physical (or not for intangibles) presence.
When preference shares are irredeemable but the right to dividends is MANDATORY AND CUMULATIVE (creating a contractual obligation to pay the dividend), what are they treated as?
Liabilities
Dividends treated as finance costs and expensed to PorL
What are the only type of irredeemable preference shares that we will see in equity?
What are dividends accounted for in this case?
- Irredeemable preference shares with no mandatory requirement to pay (or defer) dividends
- Dividends are accounted for as a reduction in equity in this case (taken from REs)
What are treasury shares?
Where the company buys back its own shares from s/hs.
Why would a company buy back its own shares?
- Alternative to dividend distribution
- Way to return excess capital to s/hs
Treatment of treasury shares?
Double entry
- Deduct from equity
- No gain/loss recognised in PorL on their purchase, sale, issue or cancellation
- Consideration paid or received should be recognised directly in equity
- Disclose amount of treasury shares held in either the SFP or in the notes to the FS
DR Treasury Shares
CR Cash
When are financial instruments recognised in the FS?
When the entity becomes a party to the contractual provisions of the instrument (ie. when they sign the contract)
How are financial instruments initially measured?
ALL financial instruments are initially measured at FAIR VALUE +/- ANY TRANSACTION COSTS
When measuring financial instruments initially, you need to measure them at their fair value +/- any transaction costs. What is the rule for adding/deducting?
- If you are the entity with the financial asset (the DR), ADD the transactions costs (ADD: ASSET)
- If you are the entity with the liability or equity (the CR), LESS the transaction costs (LESS: LIABILITY)
When measuring financial instruments initially, you need to measure them at their fair value +/- any transaction costs. What is the example for deducting?
Remember “issues” in terms of us issuing shares or loans means money in (we are borrowing in this case).
We walked out of the bank with 9mil in cash.
This means that the loan liability is also initially measured at 9mil (valued at FV less the transaction costs)
Accruals concept means that that 1 il should not be taken as a big expense on the day we take out the loan, but spread over the life of the loan, which is what will happen to it using the effective interest rate (given in the exam). AT the point we have agreed to REPAY the loan, there will be a liability of 10mil but when we walk out of the bank, the initial cost will be 9mil (FV LESS trans costs).
When measuring financial instruments initially, you need to measure them at their fair value +/- any transaction costs. What is the complicated example in the notes relating to equity?
**DEFINITION OF FAIR VALUE
IFRS 13 Fair value measurement defines fair value as the “price that would be received to SELL an asset
or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.
Within the definition of FV, what are three considerations that the standard requires?
To determine fair value, the standard requires consideration of
the principal market (ie where most activity takes place) for an asset or liability
the highest and best use of the asset or liability
assumptions that market participants would use to price an asset or liability
IFRS 13 then provides a hierarchy of inputs to arrive at fair value. What is it?
Level 1 Quoted prices in active markets for identical assets (these must be used where possible). BEST.
Level 2 Inputs other than quoted prices that are directly or indirectly observable. WE HADA GO.
Level 3 Unobservable inputs. WE MADE IT UP.
If an entity has investments in equity instruments that do not have a quoted price in an active market
and the fair values cannot be reliably calculated, they should be measured ….?
At cost
The measurement of an item after its initial recognition (subsequent recognition) depends upon what type of financial asset or liability it is, however for the purposes of the FAR syllabus all financial assets are assumed to be held to maturity (ie. we hold on to our receivable until every last penny has been paid to us, we are going to keep the shares until the end. In other words, we are not trading in these assets, we are not holding them for a short term profit). What does this mean in terms of how they will be held?
All financial instruments will be measured at AMORTISED COST (***nothing to do with the amortisation of intangibles) using the effective interest rate.
What is amortised cost?
What must you be careful about regarding interest rate?
What you borrowed plus any interest minus anything you have paid.
It is the EFFECTIVE rate of interest that we should always be using. The real rate of interest/internal rate of return.
The cash paid can be based on fake interest called coupon or nominal interest. It is how we calculate the amount of cash we are going to pay over.
what are the tables for financial assets and liabilities for amortised cost?
An entity ACQUIRES. Money in or out? Financial asset or liability?
Money out
Financial asset
DR eg Recs (they owe us money/we have lent them money)
CR Cash
What does zero coupon rate mean?
We have lent someone money but there is no cash being received each year
Double entry for financial asset (an entity ACQUIRES an asset)
Initial recognition:
DR Fin asset
CR cash
Subsequent measurement Y1:
DR Fin asset (Y1 interest ie the initial money paid which will include any transaction costs x the effective rate of interest)
CR Interest income (PorL)
Subsequent measurement Y2:
DR Fin asset (Y2 interest ie the money due at the end of Y1 (which is the money initially due plus the Y1 interest) x the effective rate of interest)
CR Interest income (PorL)
Last day when money due back to us:
DR Cash
CR Fin asset
A company LENDS - money in or out?
Financial asset or liability?
Money out
Asset (they owe us the money back)
