Chapter 4 - Financial Instruments

Question 1

Give the financial instruments in these examples:

(1) Wolverine Ltd sells £100 of goods to Storm Ltd on credit
(2) Rogue Ltd borrows £50,000 from the bank
(3) Phoenix Ltd buys 100,000 £1 ordinary shares in Cyclops Ltd

Answer 1

1)
Wolverine has a trade receivable (financial asset)
Storm has a trade payable (financial liability)

2)
Rogue has a loan (financial liability)
The bank has a receivable (financial asset)

3)
Phoenix has an investment (financial asset)
Cyclops has issued ordinary shares (equity).

Question 2

What is substance over form in relation to financial instruments?

Answer 2

If a financial instrument meets the definition of a financial liability, then it should be presented as such, regardless of its legal form.

Question 3

How do you treat redeemable and irredeemable preference shares according to substance over form?

Answer 3

• Redeemable preference shares should be classified as liabilities
• Irredeemable preference shares should be classified as equity unless there is a mandatory obligation to pay a dividend. In this case the irredeemable preference shares will also be treated as a financial liability
• Classification is made at the date of issue and should not be subsequently changed

Question 4

What is the accounting treatment of redeemable and irredeemable preference shares?

Answer 4

The accounting treatment of interest, dividends, losses and gains relating to a financial instrument follows the treatment of the instrument itself:

• Redeemable preference share dividends: should be treated as finance costs in the SPL
• Irredeemable preference share dividends should be taken through RE in SOCIE unless there is a mandatory obligation to pay the dividend in which case it will be treated as a finance cost

Question 5

How are financial instruments initially recognised?

Answer 5

All financial assets and liabilities are initially recognised at their fair value (typically the amount paid/received)

• For financial assets this is usually then adjusted for the transaction costs by adding them on (e.g. FV cash paid plus transaction costs)
• For financial liabilities an adjustment will be made for transaction costs by deducting them (e.g. FV less transaction costs)

Question 6

How are financial assets and financial liabilities measured?

Answer 6

At amortised cost using the effective interest rate
B/f: X FV (adjust for transaction costs)
Amortisation (interest): b/f amount x effective interest rate
LESS: Cash, nominal value x coupon rate of interest
C/f = Amortised cost

Question 7

What are the two characteristics of convertible bonds? (split accounting)

Answer 7

Liability: Obligation to pay annual interest and capital
- Calculate PV of future cash flows using interest rate of equivalent bond with no conversion option as discount rate

Equity: Option to convert to shares
Total value of bond
Less: Liability element
--------------
Equity element (balancing figure)

Question 8

How do you treat convertible bonds under split accounting?

Answer 8

 The liability and the equity must be shown separately in the financial statements.
 Going forward, the liability element will be held under amortised cost per IFRS 9 Financial instruments.
 Going forward, the equity element will not change

Question 9

What is a compound instrument?

Answer 9

A compound instrument is a financial instrument that has characteristics of both equity and a liability, for example a convertible bond.

Question 10

What are treasury shares?

Answer 10

This is where companies acquire their own shares as an alternative to making dividend distributions and/or as a way to return excess capital to shareholders.

Question 11

How do you treat treasury shares?

Answer 11

The treatment of treasury shares is:
 they should be deducted from equity (i.e. they are shown as negative equity)
 no gain or loss should be recognised on their purchase
 consideration paid or received should be recognised directly in equity.

Treasury shares can either be disclosed on the face of the SFP or in the notes.

Question 12

What are the two main categories of disclosures in relation to financial instruments?

Answer 12

(1) information about the significance of financial instruments
(2) information about the nature and extent of risks arising from financial instruments, and how the entity manages those risks.

Question 13

What are the two TYPES of disclosures in relation to financial instruments?

Answer 13

(1) Quantitative disclosures
 An entity must disclose the carrying value of each class of financial instrument.
 The fair value of each class of financial instrument should also be disclosed.

(2) Qualitative disclosures
 The entity must disclose information to enable users to understand management’s attitude to risk.
 Disclosures may focus on the entity’s credit risk, liquidity risk and market risk.