Financial Assets & Financial Liabilities Flashcards
What is a financial Instrument?
A financial instrument is a contract that gives rise to a financial asset of one entity and a financial Liability or equity instrument of another entity.
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What would we recognise as a financial Asset?
A financial Asset is:
- Cash (Probably in the Bank) aka Cash in hand.
- Equity instrument of another entity. i.e. Shares bought from an entity raising capital.
- Contractual right to receive cash or another financial asset - Trade Receivables.
- Contractual right to exchange financial assets or Liabilities on unfavourable terms
What is a financial liability?
A financial liability is:
- A contractual obligation to deliver cash or another financial asset i.e. trade payables.
- A contractual obligation to exchange financial assets or liabilities on unfavourable terms.
How do we determine if an instrument is debt or equity?
An instrument is classified as debt or equity according to it’s substance;
- Debt - where the issuing entity has any obligation to make payments in respect of the instrument. This can be capital, dividends or interest. All interest and dividends will be treated as expense through the P&L.
- Equity - Where there is no obligation to make payments in respect of the entity i.e the option to convert to shares.
How are financial liabilities accounted for?
- On inception - at Fair value, so Cash received less any costs incurred in issuing.
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Option 1 - Ongoing - At amortised cost, cost is adjusted annually for two factors
- Any cash repaid (interest at stated rate for the instrument)
- Any interest accrued - at effective interest rate.
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Option 2 - At fair value through the P&L, if held for trading/entity choses to do so.
- Initially measured at Fair value, any transaction costs are written off to the P&L
- Subsequently adjusted for payments & Interest accrued.as with Amortised.
- Revalued at the reporting date with any gain/loss being taken to the P&L.
What is the effective interest rate?
The effective interest rate takes in to account issue costs, discount on issue and premium due on redemption and spreads the cost over the period of the loan.
What is a compound instrument?
A compound instrument has characteristics of both a liability and equity so will be accounted for under split accounting.
These may be in the form of convertible loans where:
- The interest rate on the loan is less favourable than on a non convertible loan.
- The terms of the conversion are fixed at the loan inception.
- The lender may redeem cash or shares.
How is split accounting applied?
For the liability portion of the instrument:
The present value of cash repayments of interest and capital, discounted using the market rate for non convertible bonds, is calculated. Interest at the agreed rate for the convertible bond.
For the Equity portion
The difference between the cash received and the liability component at the issue date.
The loan liability is amortised - interest at non convertible bond rate is charged less interest paid at the agreed rate.
how is a financial asset valued?
Where a financial asset is an equity instrument of another entity it will be valued as either;
Fair value through the P&L
- Assumes that the shares are a short term investment.
- Is the default position for valuing this type of financial asset.
- Will recognise gains/losses at fair value in the SPL
- Is initially valued at fair value without costs.
Fair value through other comprehensive income
- Equity instruments held for long term strategic investment can be designated as this if conditions are met:
- Cannot be held for trading
- Cannot be later changed to FVPL
- Initial recognition will include transaction costs.
- Revalued each year to Fair value with gains/losses taken to the investment reserve.
How are Debt instruments for Bonds or redeemable preference shares Valued?
Debt instruments are valued in one of three ways:
Amortised Cost - if not held for short term trading and 2 tests are passed;
1 - Must intend to hold the investment until maturity (Business model)
2 - The cash that will be received must be comprised of Principle and interest (Contractual cash flow characteristics)
Interest income will go to SPL and the asset value at year end is calculated using amortised asset table.
Fair value through other comprehensive income - if not held for short term trading and 2 tests are passed.
Tests are the same as for amortised value.
- Asset is initially recognised at fair value plus transaction costs.
- The interest income is calculated using the effective rate of income.
- Instrument is revalued at the reporting date, any gain/loss is recognised in other comprehensive income.
Fair value through P&L
This is the default method and is exactly the same as financial instruments that are equity in another company.
What is IFRS 9?
IFRS 9 sets the criteria for when companies should de recognise Financial assets and Liabilities.
When should a financial asset or liability be de recognised?
Financial Assets - de recognised when contractual rights to cash flows expire:
- All payments attached to the asset have been made.
- The entity transferred substantially all risks and rewards to another party.
- Any difference between the carrying amount of the asset and consideration is recognised in the P&L
Financial Liabilities - de recognised when an obligation is extinguished.
- Contract is discharged/cancelled/expires.
- Again any difference between carrying amount and consideration is recognised in the P&L.
When can factored invoices be de recognised?
De recognition of factored invoices will depend if the Factoring is with or without recourse.
With recourse
- Risks and Reward are not transferred to the factor.
- Funds received are treated as a loan.
- Receivables are not de recognised.
Without recourse
- Risk & reward are transferred to the factor.
- Proceeds are recognised as a reduction in receivables.
- Receivables are de recognised.
