Topic 11 - Financial Instruments

Question 1

What are the 2 reporting standards which relate to financial instruments?

Answer 1

IAS 32 - Financial instruments: presentation

&

IFRS 9 Financial instruments

Question 2

Why is an accounting standard on financial instruments required in relation to substance over form?

Answer 2

Some financial instruments take the legal form of equity but are liabilities in substance (IE debentures/loan notes/loan stock)

Question 3

Define a financial instrument;

Answer 3

A financial instrument is any contract that gives rise to a financial asset in one entity and a financial liability or equity investment of another entity

Question 4

Describe a financial asset;

Answer 4

A financial asset is cash, or the right to receive cash from a future investment

Question 5

Describe a financial liability;

Answer 5

A financial liability is an obligation to pay cash

Question 6

Describe equity (in the context of financial instruments);

Answer 6

Equity in the context of financial instruments is a company issuing its own shares

Question 7

Describe how a financial instrument will be classified as either a “liability” or an “equity instrument” according to the economic substance of a contract;

Answer 7

Question 8

How are “compound instruments” accounted for?

Answer 8

Compound instruments, also known as hybrid instruments contain both a liability and an equity component such as a convertible bond. Recognise the PV of the liability for each year the bonds are in issue, with the balancing figure being recognised as equity;

Question 9

Describe how a financial liability should be accounted for intially then subsequently measured;

Answer 9

Financial instruments should initially be accounted for at fair value which is usually the transaction price less any transaction costs;

DR - Bank

CR - Liability

Subsequently the liability would be measured either as finacial liabilities at FV through the P&L, but in most (99%) of cases they would be recorded as financial liabilities at amortised cost. Only liabilities that the entity had incurred for trading purposes would be FVTP&L.

To account for amortised cost then;

the CV of the liability would be used to calculate the accrual for interest payable based on the effective rate. The coupon rate and the value of the issue would be used to calculate the cash flow each year. So CV plus interest accrual (DR Finance cost in the P&L, CR Liability) less cash paid in the year (DR liability CR Bank) would give the balance c/d - see image!!!!

Question 10

What are the 2 methods of subsequent measurement of financial assets?

Answer 10

1 - FV through the P&L

2 - Amortised cost

3 - FV through the OCI

Question 11

When would FV through the P&L be used as a method of subsequent measurement of a financial asset?

Answer 11

FVTPL would be used when buying and holding an asset for trading purposes, EG derivatives, investment in shares/loan notes for the purposes of trading them

Question 12

When would amortised cost be used as a method of subsequent measurement of a financial asset?

Answer 12

Amortised cost would be used when an investment is held to earn a “Fixed Cashflow” EG investment in debt such as 5% $100 debentures/loan notes/loan stock

Question 13

When would FV through the OCI be used as a method of subsequent measurement of a financial asset?

Answer 13

FVTOCI would be used for other investments which aren’t FVTP&L or Am cost. EG investment in ord. shares which aren’t intended to be traded.