Financial Instruments Flashcards
What is a financial instrument?
Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.
What is a Financial Asset?
Any asset that is:
(a) Cash
(b) An equity instrument of another entity
(c) A contractual right:
(i) To receive cash or another financial asset from another entity; or
(ii) To exchange financial assets/liabilities with another entity under conditions that are potentially favourable.
(d) A contract that will/may be settled in the entity’s own equity instruments.
What is a Financial Liability?
Any liability that is:
(a) A contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets/liabilities with another entity under conditions that are potentially unfavourable.
(b) a contract that will/may be settled in an entity’s own equity instruments.
What is an equity instrument?
Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
What is a derivative?
A derivative has three characteristics:
(a) Its value changes in response to an underlying variable (e.g. share price, commodity price, foreign exchange or interest rate);
(b) It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
(c) It is settled at a future date.
What is the critical feature of a financial liability compared to equity?
A financial liability is the contractual obligation (not right) to deliver cash or another financial asset.
What is the effect of classification between a financial liability vs equity?
Financial Liability - increased gearing and reduced reported profit.
Equity - decrease gearing and no effect on reported profit.
Classification affects how the financial position and performance of the entity are depicted and how primary stakeholders assess the potential for future cash flows and risk associated with the entity.
What are compound instruments?
How do you separate the components?
Where a financial instrument contains some characteristics of equity and some of financial liability. It’s separate components need to be classified separately (e.g. convertible loan notes).
(a) Determine the carrying amount of the liability component (PV of future cash flows).
(b) Assign the residual amount to the equity component (balancing figure).
What does an entity recognise a financial asset and financial liability?
When the entity becomes party to the contractual provisions of the instrument.
When is a financial asset derecognised?
When:
(a) the contractual rights to the cash flows expire (e.g. customer has paid their debt or an option has expired worthless); or
(b) the financial asset is transferred (e.g. sold), based on whether the entity has transferred substantially all the risks and rewards of ownership of the financial asset.
Where a part of a financial instrument (or group of similar instruments) meets the criteria for for derecognition, that part is derecognised.
When is a financial liability derecognised?
When it is extinguished - the obligation specified in the contract is discharged, cancelled or expires.
What words used in the question result in discussion of financial assets?
What are the four categories of financial assets?
How are they initially measured?
How are they subsequently measured?
Financial asset when question states ‘acquired’ or ‘purchased’.
(a) Investments in debt instruments:
1. Category: Business model approach: Held to collect contractual cash flows; and cash flows are solely principal and interest (hold until redemption date = long-term)
Initial Measurement: FV plus transaction costs
Sub Measurement: Amortised cost (finance income P/L)
2.Category: Business model approach: Held to collect contractual cash flows and to sell; and cash flows are solely principal and interest (short-term)
Initial Measurement: FV plus transaction costs
Sub Measurement: FVTOCI (reclassification to P/L on derecognition). Interest revenue calculated on amortised cost basis recognised in P/L
- (b) Category: Investments in equity instruments not ‘held for trading’ (optional irrevocable election on initial recognition)
Initial Measurement: FV plus transaction costs
Sub Measurement: FVTOCI (no reclassification to P/L on derecognition). dividend income recognised in P/L. - (c) Category: All other financial assets (and any asset that would eliminate/reduce an ‘accounting mismatch’).
Initial Measurement: FV (transaction costs expensed in P/L)
Sub Measurement: FVTSPL
How do you show the amortised cost of a financial asset?
B/d - X
Effective interest of b/d (P/L) - X
‘Coupon’ interest received - (X)
C/d - X
What words used in the question result in discussion of financial liabilties?
What are the four categories of financial liabilties?
How are they initially measured?
How are they subsequently measured?
(a) Most liabilities - long-term (e.g. TP, loans, preference shares classified as a liability):
Initial Measurement: FV less transaction costs
Sub Measurement: Amortised cost
(b) Financial Liabilities at FVTPL - short-term (‘held for trading’, derivatives that are liabilities, eliminate/reduce accounting mismatch, a group of F.L. managed and evaluated on a FV basis in accordance with risk management and investment strategy).
Initial Measurement: FV (transaction costs expensed in P/L)
Sub Measurement: FVTSPL
(c) Financial Liabilities arising when transfer of financial asset does not qualify for derecognition.
Initial Measurement: Consideration received
Sub Measurement: Measure F.L. on same basis as transferred asset (amortised cost or FV)
(d) Financial guarantee contracts and commitments to provide a loan at a below-market interest rate.
Initial Measurement: FV less transaction costs
Sub Measurement: Higher of:
- Impairment loss allowance
- Amount initially recognised less amounts amortised to P/L
When are a financial asset and a financial liability required to be offset?
When the entity:
(a) has a legally enforceable right to offset the recognised amounts; and
(b) intends to either settle on a net-basis or to realise the asset and settle the liability simultaneously.
Which financial assets are subject to impairment rules?
Financial assets measured at amortised cost.
Investments in debt instruments measured at FVTOCI (held to collect contractual cash flows and sell).
What must also be recognised alongside the recognition of a financial asset?
How is it calculated?
A loss allowance must be recognised, and at each subsequent reporting date, for expected credit losses.
Loss allowance is equal to 12-month expected credit losses
Calculation: Multiplying the probability of default in the next 12 months by the PV of the lifetime expected credit losses that would result from the default.
How are loss allowances subsequently reported?
What are the three stages of credit risk change?
The loss allowance required depends on whether there has been a significant increase in credit risk of that financial instrument since initial recognition.
Stage 1: No significant increase - recognise 12-month expected credit losses - Effective interest calculated on gross CA of financial asset.
Stage 2: Significant increase - recognised lifetime expected credit losses - effective interest calculated on gross CA of financial asset.
Stage 3: Objective evidence of impairment at the reporting date - recognise lifetime expected credit losses - effective interest calculated on net CA of financial asset.
