Financial instruments and equity

Question 1

What are the two ways for a company to raise finance?

Answer 1

debt or equity

Question 2

What is debt as a form of finance?

Answer 2

a contractual obligation to make a payment - the lender has the right to receive interest and repayment of amount lent to the company

Question 3

What is equity as a form of finance?

Answer 3

a residual interest in the net assets of the entity - investor has a share of the company’s net assets

Question 4

What is the nature, return, legal, investor risk, P&L, SFP and examples of debt?

Answer 4

• lender has lent money to company
• guaranteed interest payment
• right to receive interest and right to repayment of money invested
• low risk
• interest expense
• liability - legal obligation to pay interest and repay debt
• loans/bonds, redeemable shares, shares with fixed dividends

Question 5

What is the nature, return, legal, investor risk, P&L, SFP and examples of equity?

Answer 5

• investor has invested money in company
• dividends paid only if profit and directors decide to
• no right to receive dividends and no right to repayment of money invested
• high risk
• dividends paid
• equity - no obligation to pay dividends or repay capital invested
• ordinary shares, irredeemable preference shares with no fixed dividend

Question 6

What is a financial liability?

Answer 6

obligation to pay cash or financial asset
e.g. trade payables, bonds/loans payable, redeemable shares, shares with fixed dividend

Question 7

How is a financial liability recognised?

Answer 7

Liability measured at fair value:
- quoted price (issue price for shares)
- future payments discounted to PV (not always the same as nominal/par/face value)
- costs directly attributable to issuing debt (broker fees) deducted from liability

Question 8

When would a sales and repurchase be recognised as a financial liability?

Answer 8

when the repurchase price > original selling price

Question 9

What are convertible instruments?

Answer 9

• loans/bonds where lender has the option to convert the debt into equity
• rather than having debt repaid in cash, they can receive shares instead
• company has a liability because obligation to make interest payments
• if lender has paid > PV of payments (FV of bond) - difference is what they have paid for equity option

Question 10

How are convertible instruments recognised?

Answer 10

Liability measured at FV
- future payments discounted to PV
- used effective interest rate for a similar bond without conversion option (given in question)
- equity is measured as difference between what lender has paid and PV of payments

Question 11

What is a financial asset?

Answer 11

• right to receive cash or financial asset
• equity in another entity (cash, trade receivables, bonds/loans receivable, shares in other companies)

Question 12

How are financial assets recognised?

Answer 12

asset initially measured at FV
- quoted price
- future payments discounted to PV (not always the same as nominal/par/face value)
- costs directly attributable to acquiring asset (broker fees) capitalised

Question 13

Per IAS 33, how are earnings per share recognised?

Answer 13

• listed companies
• earnings means profit
• deduct dividend paid on irredeemable preference shares if not included in P&L

Question 14

How is earnings per share calculated?

Answer 14

profit / number of shares

Question 15

How will a new issue at market price affect earnings per share?

Answer 15

include new shares from the date of issue

Question 16

How will a bonus issue affect earnings per share?

Answer 16

comparatives restated as if the new shares have always been in issue

Question 17

How will a rights issue (new issue below market price) affect earnings per share?

Answer 17

adjustment factor to increase number of shares before rights issue (bonus element)

Question 18

How is adjustment factor calculated?

Answer 18

share price (before rights issue) / share price (after rights issue)

Question 19

How is the share price (after rights issue) calculated?

Answer 19

share price (before rights issue) + cash from share issue / new number of shares

Question 20

What are treasury shares?

Answer 20

company repurchases own shares
Dr treasury shares (equity)
Cr cash
reduce number of shares for EPS

Question 21

What are distributable reserves?

Answer 21

• dividends paid from retained earnings subject to the company having cash to make payment
• listed companies cannot pay a dividend if it will cause net assets < undistributable reserves

Undistributable reserves: share capital, share premium, revaluation reserve