Chapter 10 - Financial Assets And Financial Liabilities

Question 1

Financial instruments

Answer 1

Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Question 2

Accounting standards

Answer 2

There are three reporting standards that deal with financial instruments.

IAS 32 Financial Instruments: Presentation.
The classification of financial instruments and their presentation in financial statements.

IFRS 7 Financial Instruments: Disclosures.
How financial instruments are measured and when they should be recognised in financial statements.

IFRS 9 Financial Instruments.
The disclosure of financial instruments in financial statements.

Question 3

Financial assets

Answer 3

A financial asset is any asset that is:

• cash
• a contractual right to receive cash or another financial asset from another entity.
• a contractual right to exchange financial assets/ liabilities with another entity under conditions that are potentially favourable.
• an equity instrument of another entity.

Question 4

Financial liabilities

Answer 4

A financial liability is any liability that is a contractual obligation:

• to deliver cash or another financial asset to another entity or
• to exchange financial instruments with another entity under conditions that are potentially unfavourable or
• that will or may be settled in the entity’s own equity instruments.

Question 5

Financial assets

Answer 5

All financial assets are measured at fair value.

Likely to be the purchase consideration paid to acquire the financial asset.

Question 6

Equity instruments

Answer 6

Equity instruments (purchase of shares in other entities) are measured at either

1. Fair value through profit or loss.
   - Any transaction costs are expensed, not capitalised.
   - The investments are then revalued to fair value at each year end with the gain/loss shown in the statement of profit or loss.
2. Fair value through other comprehensive income.
   - Only be chosen if investment is not held for trading and once chosen cannot be changed to fair value through profit or loss (FVPL).
   - Under this method
   i. Transaction costs are capitalised.
   ii. The investments are revalued to fair value each year end with the gain/loss being taken to an investment reserve in equity and shown in other comprehensive income.

Question 7

Debt instruments

Answer 7

Debt instruments (such as purchase of bonds and redeemable preference shares) would be measured normally at fair value through profit or loss.

An entity could choose to adopt one of two alternative options.

1. Amortised cost
   - The business model test
   The objective of the entity’s business model is to hold the financial asset to collect the contractual cash flows.

• The contractual cash flow characteristics test.
  The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of the instrument and interest on the outstanding amount.

If a debt instrument is held at amortised cost, the interest income will be taken to the statement of profit or loss and the year end asset value is shown in the statement of financial position.

2. Fair value through other comprehensive income.
   - The business model test
   The financial asset is held within a business model whose objective is achieved by calculating contractual cash flows and selling financial assets.
   - The contractual cash flow characteristics test.
   Same as for amortised cost.

Question 8

Financial liabilities

Answer 8

1. Initial recognition
   An entity shall measure a financial liability at its fair value (net proceeds being cash received less any issue costs associated with issuing the liability).
2. Subsequent measures of financial liabilities
   After initial recognition, an entity should classify all financial liabilities (other than liabilities held for trading and derivatives that are liabilities) at amortised cost.

Question 9

Preference shares

Answer 9

If preference shares are irredeemable, they are classified as equity (unless the terms of the share carries a cumulative dividend in which case they are considered to be a financial liability).

If preference shares are redeemable, they are classified as a financial liability.

Question 10

Interests and dividends

Answer 10

The accounting treatment of interest and dividends depends upon the accounting treatment of the underlying instrument itself.

• equity dividends declared are reported directly in equity.
• dividends on redeemable preference shares classified as a liability are an expense in the statement of profit or loss.

Question 11

Compound instrument

Answer 11

A financial instrument that has characteristics of both equity and liabilities such as a convertible loan.

These are accounted for using split accounting recognising both the equity and liability components.

• the liability element as the investors may require their money back.
• the equity element as the investors may choose to convert the loan into shares instead.

To account for a convertible loan,

1. Calculate liability component first
   - Based on present value of future cash values assuming non conversion.
   - Apply discount rate equivalent to interest on similar non convertible debt instrument (discount the cash flows at the MV of interest).
2. Equity = remainder (deduct the present value of the debt from the proceeds of the issue).

Question 12

De recognition of financial instruments

Answer 12

1. Financial asset
   If and only if the contractual rights to the cash flows of the financial asset have expired.
2. Financial liability
   If and only if the obligation specified in the contract is discharged, cancelled or expires.

On de recognition, the difference between the carrying amount of the asset to liability and the amount received or paid for it should be included in the profit or loss for the period.

Question 13

Factoring of receivables

Answer 13

Where a company transfers its receivables balances to another organisation (a factor) for management and collection and receives an advance on the value of those receivables in return.

With recourse:
The factor can return any unpaid debts to the business, meaning the business maintains the risk of irrecoverable debts. In this situation the transaction is treated as a secure loan against the receivables rather than a sales.

Without recourse:
The doctors bears the risk of irrecoverable debts. In this situation, this is treated as a sale and the receivables are removed from the business’ financial statements.