Chapter 8 - Financial Instruments Flashcards
What international accounting standards are we concerned with in this chapter?
- IAS32 - Financial Instruments: Presentation
- IFRS9 - Financial Instruments: Recognition and measurement
- IFRS13 - Fair value measurement
- IFRS7 - Financial Instruments: Disclosures
Briefly outline what IAS32 establishes
IAS 32 Financial Instruments: Presentation establishes the principles for presenting financial instruments as either liabilities or equity and for offsetting financial assets and liabilities.
According to IAS32, what is the definition of a financial instrument?
A financial instrument is defined as any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.
According to IAS32, what are the 3 categories of financial instruments? Define each
- Financial assets: any asset that represents a contractual right to receive cash or another financial asset from another entity (e.g. cash, equity instruments of another entity (e.g., shares), trade receivables, loan receivables)
- Financial liabilities: a contractual obligation to deliver cash or another financial asset to another entity (e.g. trade payables, loans payable, redeemable preference shares)
- Equity instruments: any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities. Unlike liabilities, equity instruments do not create an obligation to deliver cash or other financial assets (e.g. a company’s own ordinary shares, irredeemable preference shares.)
Under IAS32, how do we account for preference shares?
Under IAS 32 the treatment of preference shares depends on whether they are classified as equity or financial liabilities. The classification hinges on the terms and conditions attached to the preference shares:
- Equity: Preference shares are classified as equity if they are irredemable and the issuer has no obligation to pay dividends, or dividends are paid only at the discretion of the issuer. In this case, the preference shares are treated as part of the equity section of the SOFP. The dividends paid on these shares are accounted for as equity distributions, not interest, in the SOCIE.
- Liability: Preference shares are classified as a financial liability if they are reedeemable and the issuer is required to pay a fixed or determinable dividend, which represents an obligation that must be settled by the issuer. In this case, the preference shares are treated as a financial liability. The dividend payments are accounted for as interest expense in the SOPL, and the liability is recorded on the SOFP.
JOURNAL ENTRIES
What is a treasury share?
A treasury share (or treasury stock) refers to shares that were issued and subsequently repurchased by the issuing company. These shares are held by the company itself and are not considered outstanding shares
Why might a company repurchase its own shares?
It is becoming increasingly popular for companies to reacquire their own shares as an alternative to making dividend distributions and/or as a way to return excess capital to shareholders.
Under IAS32, how do we account for treasury shares?
- Recognition: When a company repurchases its own shares, the repurchase is recognised in the treasury shares account in the equity section of the SOFP (the treasury shares account is a contra-equity account, meaning it reduces the total equity of the company)
- SOPL: The repurchase of treasury shares does not affect the income statement. It is a transaction within equity. The company is not recognizing an expense for the repurchase of its own shares, as this is a transaction between the company and its shareholders.
- Dividends: Since treasury shares are not considered outstanding shares, they do not receive dividends. When calculating dividends, only the shares that are outstanding (i.e., those not held as treasury stock) are considered.
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Disclosure: IAS 32 requires companies to disclose the following information related to treasury shares:
- The number of treasury shares held.
- The value of treasury shares (i.e., the cost of repurchasing them).
- Any movements in treasury shares during the period, including purchases, sales, and cancellations.
Briefly outline what IFRS9 establishes
IFRS 9 establishes the principles for the classification, measurement, impairment, and hedge accounting of financial instruments to ensure transparency and consistency in financial reporting
According to IFRS9, how should financial instruments be initially measured?
All financial instruments are initially measured at fair value +/- any directly attributable transaction costs
- Financial assets: fair value + any directly attributable transaction costs
- Financial liabilities: fair value - any directly attributable transaction costs
- Equity instruments: fair value - any directly attributable transaction costs
Briefly outline what IFRS13 establishes
IFRS 13 establishes a consistent framework for measuring fair value and provides guidance on disclosures related to fair value measurements. It does not specify when fair value should be used but explains how to measure it when required by other IFRS standards
According to IFRS13, what is the definition of fair value?
Fair value is 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
According to IFRS13, how do you determine fair value?
To determine fair value under IFRS 13, the standard requires entities to consider the following key factors:
* Principal Market:The fair value should reflect the price in the principal market, i.e., the market with the greatest volume and level of activity for the asset or liability. If a principal market is not identifiable, the most advantageous market (the one offering the best price) should be used.
* Highest and Best Use (for Non-Financial Assets): Fair value is based on the asset’s highest and best use, which is the use that maximizes its value, as perceived by market participants.
* Market Participants’ Assumptions: Fair value is determined based on assumptions that market participants would use when pricing the asset or liability, reflecting their perspectives and available market information.
Fair Value Hierarchy:
IFRS 13 also introduces a three-level hierarchy of inputs used to measure fair value:
* Level 1 Inputs: Quoted prices in active markets for identical assets or liabilities, which must be used when available.
* Level 2 Inputs:Inputs other than quoted prices that are observable, either directly (e.g., comparable prices) or indirectly (e.g., interest rates, yield curves)
* Level 3 Inputs:Unobservable inputs based on assumptions and internal models, typically used when observable inputs are unavailable. These may include estimated cash flows, entity-specific data, or industry trends.
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.
According to IFRS9, how should the value of financial instruments be subsequently measured?
The measurement of an item after its initial 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 within a business model whose objective is to hold the assets to collect contractual cash flows being the receipt of interest and capital. These receivables will be held at amortised cost.
Under IFRS9, outline the accounting treatment to recognise a financial asset with regards to initial and subsequent measurement
1) Upon issue of the receivable, the financial asset must be recognised as per IFRS9 (fair value plus transaction costs)
2) We then needed to determine what finance income will be recognised at the year end and the closing asset balance - set out the table pictured.
3) For each year, take the brought forward receivable balance and multiply it by the given effective interest rate - this will give the interest income to be recognised in the P&L for the year
4) Add the interest income for the year to the b/f balance and deduct any payments received (if applicable) for the year to give the c/f receivable balance.
5) Repeat this over the course of the term of the receivable, at the end of the receivable term the balance c/f will either be 0 if regular payments are received, or be equal to the nominal or coupon value of the asset which will then be received at the end of the receivable period
Under IFRS9, outline the accounting treatment to recognise a financial liability with regards to initial and subsequent measurement
1) Upon issue of the payable, the financial liability must be recognised as per IFRS9 (fair value less transaction costs)
2) We then needed to determine what finance charge will be recognised at the year end and the closing liability balance - set out the table pictured.
3) For each year, take the brought forward payable balance and multiply it by the given effective interest rate - this will give the interest charge to be recognised in the P&L for the year
4) Add the interest charge for the year to the b/f balance and deduct any payments (if applicable) for the year to give the c/f payable balance.
5) Repeat this over the course of the term of the payable, at the end of the payable term the balance c/f will either be 0 if regular payments are paid, or be equal to the nominal or coupon value of the asset which will then be repaid at the end of the payable period
Under IFRS9, do you split out current and non-current financial assets and liabilities?
You do split the only split out current and non-current financial assets and liabilities, it is a non-current asset/liability if the end of the asset/liability term is > 12 months and a current asset/liability if the end of the asset/liability term is < 12 months
What are compound financial instruments?
Compound financial instruments are financial instruments that have both liability and equity components embedded in a single contract. These instruments arise when a financial instrument has characteristics of both debt and equity.
The most common example of a compound instrument is convertible debt – debt that the holder has the option of converting into shares at some point in the future.
COMPOUND FINANCIAL INSTRUMENTS METHOD
Briefly outline what IFRS7 establishes
IFRS7 - Financial Instruments: Disclosures establishes the disclosure requirements for financial instruments to help users of financial statements understand the impact of financial instruments on an entity’s financial position, performance, and risk exposure.
According to IFRS7, what are the disclosures necessary to be included in the financial statements
- The carrying amount for each category of financial instruments.
- The fair value for each class of financial instrument.
- Narratives to help users understand management’s attitude to risk, including
- Credit risk
- Liquidity risk
- Market risk
See IAS handbook
Outline the key differences between UK GAAP and IFRS for financial instruments
