Theory 2.0 Flashcards
Definition of a financial instrument
Financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability of another entity.
A contract is an agreement between two or more parties that have clear economic consequences. It is also enforceable by law which means contracts, and thus financial instruments, may take a variety of forms and may not always be in writing
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 from another entity or a contractual right to exchange financial assets or financial liabilities under conditions that are potentially favourable to the entity
A financial liability is any contractual obligation to deliver cash or another financial asset to another entity to a contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity
Categories of financial instruments
Under IAS 32/39 and IFRS 7, the standard categories of assets/liabilities are: held for trading, held for maturity, loans and receivables and available for sale.
Available for sale and held for trading are measured at fair value
Loans and receivables and held to maturity and measured at amortised costs using the effective interest method. They are assets that have fixed or determinable payments and are not quoted in an active market/ These assets are valued at amortised cost in the SoFP. Examples include loans and mortgages.
Any financial asset that does not have a quoted market price in an active market and whose fair value cannot be reliably measured is valued at amortised cost.
Held for trading are assets intended to generate a profit for short-term price fluctuations. These assets are measured at fair value on the SoFP with gains and losses being posted through the income statement. Examples include ordinary shares,m irredeemable preference shares, bonds, and derivative contracts.
Held to maturity are assets with fixed or determinable payments and fixed maturity that the company intends to hold until maturity, irrespective of changes in market prices or the company’s position. Examples include: Redeemable preference shares, bonds, and forward contracts.
Problems with accounting for financial instruments
Financial instruments are an increasingly complex way of raising finance and there are problems with accounting for derivatives such as forwards, futures, swaps, etc.
The accounting problem revolve around recognising, measuring, presentation and disclosure of such instruments in the financial statements of an entity
Many Unrealised gains/losses on many financial instruments went by unrecognised and companies could choose when to recognise profits to smooth over their profits. This all brought forward a need for accounting standards to tackle finan
IAS 39 and IFRS 9
IAS 39 Financial Instruments: Measurement
IFRS 9 Financial Instruments
IAS 39 was more of a serie of questions and answers
IAS 39 was seen as being a contributor the to the economic crisis of 2008 as it permitted entities which held the same financial instruments as another to measure them in different ways
Eg. held for trading = immediately recognise unrealised profit/losses whilst available for sale had equity and unrealised gains passing through until recognised
IAS 39 was not universally recognised as EU prohibited the use of fair value option for financial liabilities
Replacement of IAS 39 was seen as a matter of urgency
IFRS 9 deals with classification and measurement of financial assets only
IFRS 9 moves accounting beyond its traditional methods and attempts to capture the rights and obligations of complicated financial instruments which provides more useful information to the users if its made understandable to them and less complex than IAS 39
Under IFRS 7 it is possible to designate a financial asset as ,measured at fair value through profit and loss if in so eliminates accounting mismatch
IFRS 9 also give further guidance on who determines the business model of an entity
If an entity change sits business model for managing financial assets then it will need to reclassify its financial assets
Disclosures
Disclosures are set out in IFRS 7: DIsclosures.
It requires the classification of FI as a liability or equity using substance over form and the reporting of interest, dividends, losses and gains from a financial instrument.
An equity instrument is an contract that evidences a residual interest in the assets of an after deducting all its liabilities and there is no contractual obligation to deliver cash or another financial asset to another equity eg holders of ordinary shares in a company own equity instruments
A financial liability is any contractual obligation to deliver cash or another financial asset to another entity to a contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity
Entities must provide sufficient information so users can evaluate
the significance of an on balance sheet and off balance sheet financial instruments in an enterprise’s financial position, performance and cash flows
the risk management policies of the organisation
the of terms, conditions and accounting policies in relation to all financial assets financial liabilities and equity
The exposure to interest rate risk and credit risk in all financial assets and financial liabilities
information on fair values e.g. method used to determine fair value
Define control
IAS27: Control is the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities.
Control is presumed to exist when an invetsor owns, either directly or indirectky through subsidiaries, more than 50% of the voting power of an entity
Benefit of having group accounts
- Improved accountability
- Financing
- raise more finance
- diversification
- Provision of security
- consolidated as one entity
- Disposals
- short - term investement
- Dispose in future to make profit
The need for financial accounting regulation
To help fulfil user needs:
Many, although, not all, of the information requirements are essentially forward looking
Different users, with different purposes, may require different information about the same items
Different users will require (and be able to understand) different degrees of complexity and depth
Good accounting regulations provide good quality financial information (good GAAP)
Fundamental qualitative characteristics
Relevance
Faithful representation
Enhancing qualitative characteristics
Comparability
Verifiability
Timeliness
Understandability
Started off as only internal reporting but the increasing scale of companies resulted in finance problems and the need for a disconnection of management and capital supply
The importance of qualitative characteristics of useful financial information
Qualitative characteristics are the attributes that make the information provided in the financial statement useful to users
Fundamental qualitative characteristics
Relevance
Good quality of relevance influences the economic decisions of users by helping them to evaluate past, present or future events or confirming, or correcting, their past evaluations.
Faithful representation
To be reliable, information must be represented faithfully
Most information will have some difficulty due to problems in identifying transactions and events and different presentation techniques that kay portray a different message
Enhancing qualitative characteristics
Comparability
Users must be able to compare this financial year to previous financial year or compare with another company
Must be consistent
International accounting standards help achieve this
Verifiability
Timeliness
Late information lay lose its relevance
DUe to thai, sometimes have to provide information before all specs are known, reduction reliability but the informato=ion may have little use to users if it comes out later
Understandability (to someone with reasonable knowledge of business and economic activities)
Globalisation and its impact towards financial reporting standards.
Push to improve comparability
Information is only seek for decision-making if it can be compared to a certain benchmark
If too much differentiation then the financial reports become meaningless
IASB creation in 1973
Develop a single set of high quality, understandable and enforceable global standards that require high quality, transparent and comparable information
To promote the use of rigorous application of these standards
To take account of the special needs of SMEs and emerging countries
To bring a boy convergence if ntuarak accounting standards and IAS and IFRS to high quality solutions
Heading towards iFRS globally but the issue is convergence with US GAAP
Agreement to have a new set of standards instead of changing their standards to fit each other
Slow process
Same mission, different environmental, institutional and cultural influences changed standards internationally
Distinctions between credit/fami;y/ state oriented entities and shareholder-protonated entities
Required different information to different degrees
Inconsistency in financial reporting when there is flexibility in applying accounting standards.
Low quality GAAP allows management flexibility to report results when they want to report those results
Impacted by:
Degree of investor protection
The degree of enforcement of financial accounting standards
The risk of litigation
The reliability legal system
users of financial statements of companies located in countries with accounting flexibility will face more problems comparing the performance of different companies with one another than users of annual accounts of companies located in countries with very little accounting flexibility
However, the performance and the financial position of another company is only a yardstick for evaluation if comparability is not jeopardised by accounting flexibility, which is to a large extent determined by the type of accounting standards used or other factors (e.g. legal system, the degree of enforcement of accounting standards, the risk of litigation, culture, the reporting incentives of management
The future of regulation is standardisation and harmonisation
Brought upon the comparability project
Took voluntary international accounting standards adoption to compulsory
Convergence between UK and US GAAP
Wake of 2008 financial crisis furthered the push for convergence
Optimal level of disclosure by companies to avoid excessive amount of info disclosed – information overloaded
Although companies must provide a minimum level of disclosure as required by the GAAP they are complying with, the management team can always make more voluntary disclosures. Disclosure quality refers to the compliance of a company to all the disclosures required by the GAAP and to the informativeness of the voluntary disclosures which are presented in the annual rep
The analytical research, however, indicates that there is an optimal level of disclosure for a company.
Adequate disclosure in the notes on the methods and the estimates used might enable external analysts to get an idea of the impact of the choice and to reconcile earnings of different firms when executing a comparative financial analysis of comp
