IAS 32 & IFRS9 - Financial Instruments

Question 1

Identify the relevant classification and double entry for each of these financial instruments:

Ordinary Shares
Loans
Preference Shares
Debentures / Loan Stock / Loan Notes / Bonds
Convertible Loans

Answer 1

• Ordinary Shares - Equities.
• Loans - Dr Cash : Cr Liabilities
• Preference Shares : Liabilities - Dr Cash : Cr Liabilities
  (If shares are redeemable future obligation to repay, if irredeemable but have a fixed coupon rate would mean long term liability.)
• Debentures / Loan Stock / Loan Notes / Bonds: Depends. May require split accounting (Dr Cash : Cr Liability : Cr Equity).

Question 2

Explain using split accounting on a compound instrument.

An instrument that has elements of both liability and equity. i.e. convertible loan.

Answer 2

Split the loan at inception between equity and liability.

• we start with calculating the liability element.
• We will require the market rate for non-convertible bonds to use as our discount rate.
• We will calculate the present value of the cash repayments (coupon rate of loan amount).
• NPV = the Liability element.

Equity element
- Loan amount - Liability element = Equity element

1. Gather the Coupon % rate, and equivalent non-convertible bond interest rate.
2. Calculate cashflows using coupon rate.
3. Discounting table at the DF of the non-convertible bond interest rate,
4. The NPV is the Liability value.
5. Loan amount less liability value = equity value.

Question 3

Accounting standards for financial instruments.

IAS32 - Financial instruments: Presentation.

IFRS7 - Financial instruments: disclosures. (Not examinable in F2)

IFRS9 - Financial Instruments.

Answer 3

IAS32 - Dealing with the classification of financial instruments and their presentation in financial statements.

IFRS7 - Dealing with the disclosure of financial instruments in financial statements (not examinable in F2)

IFRS9 - Dealing with how financial instruments are measured and when they should be recognised in financial statements.

Question 4

IFRS 9
Initial recognition
classification

Answer 4

Initial Recognition
- initially recognised at its fair value. The net of cash received (total cash received) less any issuing costs.
- if notes are issued at a discount the calculation is:
Nominal Value * (1-discount %) - Issuing costs = Initial Measurement.

Classification
- Financial liabilities need to be classified as being held at either amortised cost or fair value through profit or loss.
- Default for financial liabilities is usually to account for them at amortised cost.
[Will require an Amortised cost table]
- If they are derivatives or held for trading they may be classified as fair value through profit or loss.

Question 5

IFRS9 Financial Equity Instruments (shares of another company)

Explain the different designations (FVPL, FVOCI), their initial recognition and subsequent recognition.

Answer 5

Fair Value through Profit or Loss (FVPL)
- This is the default classification or;
- if the asset is being held for trading.
+Initial Recognition
- Fair value - Issue cost and transaction costs expensed to P&L.
+Subsequent Recognition
- Revalue to fair value
- Gain or losses to P&L

Fair Value through Other Comprehensive Income (FVOCI)
- The classification used for assets not held for trading
- Cannot be changed from FVOCI once designated.
+Initial Recognition
- Fair Value - transaction costs are capitalised (added to fair value)
+Subsequent recognition
- Revalue to fair value
- Gains or losses to SOCIE
- Reserves to SOFP

Question 6

IFRS9 Financial Debt Instruments (debt of another company)

Explain the two tests used to determine the correct designation and also explain each of the designations (Amortised cost, FVOCI, FVPL)

Answer 6

Debt financial assets include Bonds, Debentures, Loan Notes.

At initial recognition a debt financial asset can be designated as either FVOCI or Amortised Cost based on the outcome of two tests:
1 .Business Model Test
- To hold assets and collect all contractual cash flows + “2” = Amortised Cost
- To Hold some of the assets until maturity and sell some + “2” = FVOCI

2. The contractual Cashflow Test
   
   • Cash flow receipts are solely repayments of principle and interest on the principle amount.

If not designated as either Amortised Cost or FVOCI then FVPL should be used.

Amortised Cost
- Will require an Amortised Cost Table
\+ Initial Recognition
- Fair Value (Cost) - Transaction costs are included.
\+Subsequent Treatment
- At Amortised cost

FVOCI
+Initial Recognition
- Fair Value (Cost) - Including transaction costs
+Subsequent Treatment
- Revalue to fair value
- Gain or Loss to SOCIE and reserves to SOFP
Note: upon disposal the gain/loss transfers to P&L from OCI.

FVPL
\+Initial Recognition
- Fair Value (Cost) - transaction costs expensed to P&L.
\+Subsequent treatment
- Revalue to fair value
Gain/Loss to P&L

Question 7

Why is the WACC important?

Why WACC may not be correct to use?

Answer 7

By calculating the WACC as an average of all the costs of finance, the company can use this as a target rate of return for its own operations. If the company can generate at least the same % of the WACC then it will be able to satisfy its financing costs and can therefore be used as a baseline when assessing projects.

If a project requires more external long-term funding it has two potential effects on the WACC.

1. The proportions of debt and equity will change having a direct effect on the WACC calculation.
2. Taking on more long-term funding to do an investment project can affect the shareholders’ perceptions of the risk levels of the business. For instance, if the company takes on more debt funding, the shareholders may feel that it will become less likely that they will receive their dividend payments. Or if the project that is being invested in has a different risk level than the current business operations that could also affect the shareholders’ view of the risk they are exposed to. This could result in shareholders demanding a higher return than they are currently getting (Ke)

Another factor to consider is the company’s current gearing ratio (debt to equity finance)

• Higher gearing means the company is at greater risk of not making its debt repayments and is more sensitive to a downturn in the economy.
• Too low a gearing could result in earnings dilution.

Question 8

Explain Derivative Financial Instruments with an example, also explain their recognition and measurement.
Hint: “…derives from…”

Answer 8

A financial instrument that derives its value form the value of an underlying asset, price, rate or index.

e. g.
- Futures
- Options
- Forward Contracts
- Forward Rate Agreement (Interest Rate)
- Currency Swaps

Recognition and Measurement

• Fair Value through Profit or Loss.
• At each reporting date they are revalued to fair value and is recorded as a financial asset or as a financial liability in the SFP.
• Any gains/losses are recorded on the SPL.

Question 9

IAS32- Financial Instruments: Presentation

Answer 9

The issuer of a financial instrument must classify it as a financial liability or equity instrument on initial recognition according to its substance.

Financial Liabilities

• if the issuer has a contractual obligation:
  
  • To deliver cash (or another financial asset) to the holder.
  • To exchange financial instruments on potentially unfavorable terms.

Equity Instruments
- If no such contract exists.