Financial Instruments Flashcards
What is a financial instrument?
Which accounting standard is it and how is it defined?
3 parts and examples of them?
Defined in IAS 32 Financial Instruments: Presentation as:
Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another
Financial asset of one entity
- e.g. cash,
- equity instrument of another entity or contractual right to receive cash or other financial asset
- (NOT physical assets, prepayments, warranty obligations)
Financial liability
- e.g. contractual obligation to deliver cash/financial asset
- or entity’s own equity instruments
Equity instrument
- Provides residual interest in the assets of an entity after deducting all liabilities
- Ordinary shares are the most common
Therefore - two parties, to be recognised as an asset by one party and either a liability or equity by the other
Objective of IAS 32
What does it enhance?
How should financial instruments be classified?
Reminder?
Transactions recorded in…must…?
- To enhance a user’s understanding of the effect of financial instruments on the financial position, performance and cash flow of an entity
- Financial instruments should be classified according to the substance of the contract, not necessarily its legal form
Reminder: substance over form
- Transactions recorded in the financial statements and accompanying disclosures of a company must reflect their economic substance rather than their legal form.
Financial assets and financial liabilities
The following are not financial instruments (IAS 32: par 11-14): (3)
Certain assets may…?
Is there a contractual right/obligation to receive/deliver cash or another financial asset?
The following are not financial instruments (IAS 32: par 11-14):
- Physical/intangible assets
- Prepayments
- Most warranty obligations
Certain assets may generate economic benefit but there may be no contractual right to receive cash/another financial asset
IAS 32 Financial Instruments: Presentation
Classify at time of issue according to the substance of the contract as follows: (3)
Offsetting (netting) financial assets and financial liabilities is only permitted if: (2)
Classify at time of issue according to the substance of the contract as follows:
Asset
- If contractual obligation to receive cash or another financial asset
Equity
- If no obligation to transfer economic benefit
Liability
- If contractual obligation to deliver cash or another financial asset
Offsetting (netting) financial assets and financial liabilities is only permitted if:
- There is a legally enforceable right to set off the recognised amounts and
- The entity intends to settle on a net basis, or to realise the asset and settle the liability simultaneously.
Ordinary and Preference shares (4 differences)
Ordinary shares
- Voting rights
- Receive dividends from profits of company
- If company wound up they are repaid after preference shares
- Treated as equity
Preference shares
- Generally no voting rights
- Priority for dividends
- If company wound up they are repaid after other creditors but before ordinary shares
- Treatment depends on their nature
Preference Shares
Redeemable (1) vs Irredeemable (2)
In line with ‘substance over form’…
Redeemable
- Usually treated as a liability in substance as contractual obligation to pay dividends and repay the capital
Irredeemable
- If dividends are mandatory and cumulative, then contractual obligation to deliver cash or other financial asset – liability
- If dividends are discretionary then no contractual obligation – equity
If redeemable = classify as a liability
Example 1 – preference shares
Strawberry plc issues 50,000 4% preference shares, which are redeemable at a premium by Kiwi plc in 8 years’ time. The dividend is payable annually.
- Is there an obligation to transfer financial assets at some future time?
- Is there a contractual obligation to pay dividends on the shares?
Yes and yes they are mandatory
Example 2 – preference shares
Raspberry plc issues 20,000 preference shares, redeemable only at the option of Blueberry plc. A dividend is payable on these shares at the same amount per share as any ordinary dividend declared in the year.
- Is there an obligation to transfer financial assets at some future time?
- Is there a contractual obligation to pay dividends on the shares
No and no, they are discretionary
No contractual obligation= Classify as equity
Example 3 – preference shares
Lime plc issues 10,000 irredeemable preference shares to Peach plc with a coupon rate of 5% per annum. The payment of the dividend is mandatory and if it is unpaid at the end of the period then it becomes cumulative the following period.
- Is there an obligation to transfer financial assets at some future time?
- Is there a contractual obligation to pay dividends on the shares?
No and yes, they are mandatory
Contractual obligation= Classify as liability
Equity vs liability
Liabilities have the drawbacks of (6)
- Perception on company may change
- Debt covenants
- Gearing ratios
- Interest cover
- Reduction in net assets
- Perceived credit risk
Treasury shares
What are they?
Accounting treatment (4)
Equity instruments that are reacquired by the company i.e. share buyback
Accounting treatment:
- Deduct from equity (separate reserve)
- Do not recognise gains/losses on purchase, sale, issue or cancellation
- Consideration paid or received should be recognised in equity
- Amount of treasury shares held disclosed in SoFP or notes
Dr Treasury Shares
Cr Cash
Example - treasury shares
There is no gain/loss on repurchase
Offsetting
When can it happen
- Separate presentation of financial assets/financial liabilities
- Unless:
Entity has legal right of offset and;
Entity intends to settle on net basis
Offsetting example
Issue costs (what are they)
Incremental transaction costs related to the issue of equity instruments should be deducted from equity
Issue costs example
Initial Recognition
Where is it dealt with in?
What does it state?
What is required?
Dealt with in IFRS 9 Financial Instruments
- In general, financial assets/liabilities should be recognised when entity enters into the contractual provisions of the financial instrument
IFRS 9 requires recognition of all financial assets and financial liabilities in the Statement of Financial Position
Measurement (2)
- Initial measurement will be at fair value (this may include non-cash items) plus transaction costs
- If no quoted price available, or FV impossible to calculate, use cost
IFRS 7 Disclosures
Disclosures are required to enable users to evaluate: (2)
Disclosures are required to enable users to evaluate:
- The significance of financial instruments for the entity’s financial position and performance, and
- The nature and extent of risks arising from financial instruments to which the entity is exposed, and how the entity manages those risks
