Lecture 8 Financial Instruments

Question 1

What is a financial instrument?

Answer 1

Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Question 2

What is a financial asset?

Answer 2

Cash

An equity instrument of another entity

A contractual right to receive asset from another entity or exchange assets or liabilities with another entity under conditions that are potentially favourable to the entity

A contract that will or may be settled in the entity’s own equity instruments

Question 3

What is a financial liability?

Answer 3

A contractual obligation to deliver an asset to another entity or to exchange assets or liabilities with another entity under conditions that are potentially unfavourable to the entity or

A contract that will or may be settled in the entity’s own equity instruments.

Question 4

What is an equity instrument?

Answer 4

Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Question 5

The distinction between debt and equity is of great concern to many reporting entities because classification affects what?

Answer 5

Solvency ratios
Debt covenants
Capital adequacy ratios
Interest versus dividends

Question 6

An instrument shall be classified as an equity instrument if what?

Answer 6

There is no contractual obligation to deliver assets or exchange assets and liabilities that could be unfavourable to the issuer.

Question 7

Paragraph 5.1.1 of IFRS 9 requires that, on initial recognition financial assets and financial liabilities at fair value through profit and loss are measured at what?

Answer 7

Fair value

Question 8

Financial assets and financial liabilities NOT at fair value through profit and loss are measured at what?

Answer 8

Fair value plus or minus transaction costs.

Question 9

Fair value is defined by IFRS 13 as what?

Answer 9

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Question 10

Amortised cost is defined in IFRS 9 as what?

Answer 10

The amount at which the financial asset or financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount (and, for financial assets, adjusted for any loss allowance).

Question 11

The effective interest method calculates the amortised cost of a financial asset or a financial liability and allocates interest revenue or interest expense in profit or loss over what?

Answer 11

The relevant period.

Question 12

The effective interest rate is defined by IFRS 9 as what?

Answer 12

The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability.

Question 13

Fair value is what?

Answer 13

The price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.

Question 14

Fair value measurements are classified according to a three level hierarchy determined by the observability of their inputs. What is level 1.

Answer 14

Level 1 inputs are quoted prices in active markets for identical assets or liabilities (mark to market).

Question 15

Fair value measurements are classified according to a three level hierarchy determined by the observability of their inputs. What is level 2.

Answer 15

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable either directly or indirectly for the asset or liability.

Question 16

Fair value measurements are classified according to a three level hierarchy determined by the observability of their inputs. What is level 3.

Answer 16

Level 3 inputs are unobservable inputs for the asset or liability.

Question 17

A derivative is a financial instrument or other contract within the scope of IFRS 9 with all three characteristics. What are they?

Answer 17

Its value changes in response to the change in a specified variable.

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.

it is settled at a future date

Question 18

What is a stock option?

Answer 18

A stock (share) option is a derivative, sold by one party to another, that gives the buyer the right, but not the obligation, to buy or sell a stock at an agreed-upon price within a certain period of time or at a specified date.

Question 19

When is a stock option considered a call?

Answer 19

A stock option is considered a call when a buyer enters into a contract to purchase a stock at a specific price by a specific date.

Question 20

When is a stock option considered a put?

Answer 20

An option is considered a put when the option buyer takes out a contract to sell a stock at an agreed-on price on or before a specific date.

Question 21

What is offsetting?

Answer 21

Offsetting is the practice of using a net amount for an asset and a liability to show a single amount on the balance sheet, rather than showing separate gross figures for both the asset and the liability.

Question 22

Paragraph 42 of IAS 32 states that a financial asset and a financial liability shall be offset and the net amount presented when, and only when, an entity:

Answer 22

Currently has a legally enforceable right to set off the recognised amounts; and

Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

Question 23

What are compound financial instruments?

Answer 23

Instruments with characteristics that are a combination of a financial asset, a financial liability and equity component.

Question 24

What are contingent convertibles?

Answer 24

Investors in contingent convertibles agree to exchange their debt for equity if the bank’s capital ratio falls below a certain point.