Financial Instruments

Question 1

What is a financial instrument?

Answer 1

IAS32: A financial Instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity

Question 2

What is a financial asset?

Answer 2

Cash
Right to receive cash
Equity

Question 3

What is a financial liability?

Answer 3

Contractual obligation to deliver cash

Question 4

What is an equity instrument?

Answer 4

Evidence of ownership

Question 5

How are financial assets created?

Answer 5

by providing finance to another entity.

Question 6

How are financial liabilities created?

Answer 6

Created by borrowing (issuing bonds/loan stock).

Question 7

How are equity instruments created?

Answer 7

issuing equity/ investing in equity of another entity.

Question 8

What are the three types of financial instruments?

Answer 8

FVPL-Fair Value through Profit or Loss (Held-for-trading): purchased and held primarily for sale in the short term and NOT to maintain ownership.
Held-to-maturity: instruments or equities that a firm plans on holding until their maturity dates.
Available for sale: purchased with the intent of selling before it reaches maturityor holding it for a long period should it not have a maturity date

Question 9

How do you recognise assets and liabilities?

Answer 9

A financial asset or liability should be initially recognised at fair value (cash paid/received)
Subsequent measurement of other financial instruments depends on how that particular financial instrument is classified

Question 10

What are 4 types of financial assets?

Answer 10

financial assets at fair value through profit or loss (held for trading)
held-to-maturity investments
loans and receivables
available-for-sale financial assets

Question 11

What are 2 types of financial liabilities?

Answer 11

at fair value through profit or loss(held for trading)
at amortised cost (all liabilities except FVPL)

Question 12

What are financial liabilities?

Answer 12

Created by issuing bonds/loan (borrowing) stock/debentures/redeemable preference shares
issuer has a contractual obligation:
- to deliver cash (or another financial asset) to the holder
- to exchange financial instruments on potentially unfavourable terms.
-a contract that will or may be settled in the entity’s own equity

Question 13

How do you initially measure a liability?

Answer 13

initially recognised at fair value.

Issue costs are deducted from liability unless liability is classified as FVPL.

If financial liability is FVPL, issue costs are expensed in SOPL.

Question 14

What are amortised costs?

Answer 14

Eg loans payable.
Amortised cost of a liability = initial cost + interest - repayments
Interest charged on the outstanding balance at the effective interest rate.
Effective interest rate: constant rate that spreads total finance cost (discounts, premium and coupon repayments) across the life of loan.

Question 15

What are the accounting entries for amortised financial liabilities?

Answer 15

Opening bal. net proceeds (after deducting discounts/issue costs):
Dr Cash; Cr Liability

Effective interest charged to SOPL:
Dr Finance cost (SOPL); Cr Liability

Coupon payment:
Dr Liability: Cr Cash

Question 16

What is a compound instrument?

Answer 16

A financial instrument with characteristics of both equity and liability.
eg. debt that can be converted into shares- Convertible bond.

Question 17

How are compound instruments split?

Answer 17

IAS 32: compound financial instruments be split into their component parts on initial recognition:
– a financial liability (the debt)
– an equity instrument (the option to convert into shares).

Question 18

What is the financial liability (debt part of a compound instrument)?

Answer 18

financial liability (the debt): measured at the present value of the future cash flows, including redemption, using a discount rate that equates to the interest rate on similar instruments without conversion rights

Question 19

What is the equity instrument (the option to convert into shares)?

Answer 19

calculated as the balancing figure
shown separately in the financial statements.
The liability component is measured at amortised cost and equity component remains unchanged
Any transaction costs would be pro-rated between equity and liability component based on their values