Week 4 Flashcards
The business model test
The business model test requires the entity to assess whether the objective of holding the financial asset is to generate contractual cash flows (e.g., interest on a corporate bond), or realising a fair value change from the sale of the instrument (e.g., realising a gain from the sale of the bond), or a combination of the two.
The cash flow characteristics test
The cash flow characteristics test asks whether the cash flows from the financial asset are on specified dates, solely payments of principal and payments of interest on the principal outstanding.
financial instrument
“any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity”
There are three key components:
* a contract (i.e., an agreement between two or more parties)
* a financial asset, and
* a financial liability or equity instrument.
What is a Financial Asset?
A financial asset under NZ IAS 32 is defined as cash, an equity instrument of another entity, or a contractual right to receive cash or another financial asset from another entity that gives rise to a financial liability or equity instrument in another entity.
- It also includes a contractual right to exchange financial instruments with another entity under conditions that are potentially favorable.
Measurement Base: FV
Key components of a financial asset:
- contractual right
- arising from a past event
- provides future economic benefit
- results in a financial liability or equity of another entity.
Examples:
cash in bank
investment in a government or corporate bond
purchase of shares in another company
stocks, bonds
bank deposits
What is a Financial Liability?
a contractual obligation to deliver cash to another entity that gives rise to a financial asset in another entity.
Loans
Bonds Payable
Trade payables
financial contracts.
Measurement Base: FV
Key components of a financial liability:
- contractual right
- arising from a past event
- results in an expected outflow of economic benefits
- results in a financial asset of another entity.
Examples:
accounts payable
loan from bank
issue of bonds to investors
share options
Primary financial instruments
Primary financial instruments include receivables, payables and equity securities such as ordinary shares.
A derivative financial instrument
A derivative financial instrument “derives” its value from underlying financial instruments, commodities, prices or an index.
Eg.
financial options,
futures, forward contracts
interest rate swaps and currency swaps.
Key features of a derivative are that:
- Its fair value changes based on changes in value of an agreed underlying variable, e.g., interest rate swaps are based on movements in the underlying interest rate.
- It requires little or no net initial investment. The cost to enter into a derivative is usually zero, particularly for the common derivatives such as interest rate swaps or forward rate contracts.
- It is settled at a future date.
Debt vs. Equity – why is this important?
Classification as debt or equity is important for the following reasons:
Profit: if an item is classified as debt the related payments will include interest expense which reduces profit: vs, if an item is classified as equity the related payments will be dividends which do not reduce profit.
Debt to Equity Ratios: if an item is classified as debt, it is a liability which means an obligation to make future payments: vs, if an item is classified as equity there is no obligation to make future payments.
Equity instrument is:
Any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities.
Compund instrument is:
A financial instrument with both liability and equity components.
Measurement Base: FV
A financial asset should be measured at amortised cost subsequent to initial recognition if:
It is held to collect contracted cash flows and the contractual terms of the financial asset have specified dates where cash flows of principals and interest on the principal amount outstanding.
A compound financial instrument is measured by:
Calculating the FV of the instrument as a whole and deducting the FV of the liability component leaving the residual amount which is the equity component.
