IAS 32 - Financial Instruments - Presentation Flashcards
What is the definition of a financial asset?
A financial asset is any asset that is: > Cash > An equity instrument of another entity > A contractual right to receive cash or another financial asset > derivative standing at a gain
What is the definition of a financial instrument?
A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
What is the definition of a financial liability?
A financial liability is a contractual obligation to : -
> deliver cash or another financial asset
> to exchange financial assets or liabilities with another entity unfavourable to the entity
> a contract settled in a variable number of own shares
> a derivative standing at a loss
What is the definition of an equity instrument?
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. There is no contractual obligation.
EXAMPLE : - Holders of ordinary shares in a company own equity instruments. They have no contractual right to demand a dividend.
What is the definition of a derivative?
A derivative is a financial instrument or other contract with the 3 following characteristics : -
1) It requires no initial net investment
2) Its value changes in response to changes in a specified variable
3) It is settled at a future date
What are common examples of derivatives?
Forward contracts, SWAP and options
Why is the classification of a financial instrument important?
The classification is important as it changes the perceived risk of the entity. The classification of an instrument as a financial liability will potentially have an adverse effect on the gearing ratio of a company and may reduce its ability to obtain further debt funding.
Explain the concept of substance over form with reference to preference shares?
Preference shares provide the holder with the right to receive an annual dividend, together with a fixed amount on the ultimate liquidation of the company. The legal form of the instrument is equity.
In substance the fixed level of dividend is interest and the redemption amount is a repayment of a loan.
REDEEMABLE PREFERENCE SHARE = Financial liability as the fixed dividend is interest and the redemption amount is repayment of a loan.
IRREDEEMABLE PREFERENCE SHARE = Equity instruments
What is a compound financial instrument?
A compound financial instrument is one that contains both a liability component and an equity component. As an example, an issuer of a convertible bond has :
> The obligation to pay interest and eventually repay the capital - THE LIABILITY COMPONENT
> The possibility of issuing equity should the bondholders choose the conversion option - THE EQUITY COMPONENT
How are compound financial instruments presented in the financial statements?
At the date of issue the components of such instruments should be classified separately according to their substance. This is often called “split accounting”. The amount received on the issue should be allocated between the separate components as follows:
> The fair value of the liability component should be measured at the PRESENT VALUE of the periodic interest payments and the eventual capital repayment. The present value should be discounted at the market rate of interest for a similar debt without the conversion option.
> The fair value of the equity component should be measured as the remainder of the net proceeds.
EXAMPLE : - An entity issued 10,000 6% convertible bonds at par value of £100. Interest is payable annually in arrears. The market rate of interest for similar debt without the conversion option is 8%.
Each bond is convertible into 4 shares in two years time.
SOLUTION : -
YEAR CASHFLOW DISCOUNT FACTOR NPV
1 £60,000 (W1) 1/1.08 n1 £55,556
2 £1,060,000 (W2) 1/1.08 n2 £908,779
————
TOTAL LIABILITY COMPONENT £964,335
TOTAL PROCEEDS (10,000 x £100) £1,000,000
————-
EQUITY ELEMENT (diff) £35,665
(W1) = 10,000 x 6% x £100 = £60,000 (W2) = 10,000 x 6% x £100 = £60,000 + £1,000,000 (W3) = £964,335 x 8% = £77,147
DR BANK £1,000,000
CR CUR LI BORROWINGS £55,556
CR NON CUR BORROWINGS £968,779
CR EQUITY £35,665
CR INTEREST REC P&L (W3) £77,147
DR INTEREST PAYABLE £60,000
DR CUR LI BORROWINGS £77,147
CR CUR LI BORROWINGS £60,000
What are treasury shares and how should they be treated?
Treasury shares are the name given where equity instruments are reacquired by the entity which issued them. Companies reacquire their own shares as an alternative to making dividend distribution or as a way to return excess capital to shareholders.
How should an ordinary dividend and a dividend on a redeemable preference share be presented in the financial statements?
ORDINARY DIVIDEND = Statement of Equity
REDEEMABLE PREFERENCE SHARE = Profit and Loss
