11 Financial Instruments

Question 1

What is a financial instrument?

Answer 1

Any contract that gives rise to both 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

Any asset that is: (a) Cash (b) An equity instrument of another entity (c) A contractual right to receive cash or another financial asset from another entity; or to exchange financial instruments with another entity under conditions that are potentially favourable to the entity

Question 3

What is a Financial liability?

Answer 3

Financial liability. Any liability that is: (a) A contractual obligation: (i) To deliver cash or another financial asset to another entity, or (ii) To exchange financial instruments with another entity under conditions that are potentially unfavourable.

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

Define Fair value?

Answer 5

Fair value. 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 6

Examples of financial assets include

Answer 6

(a) Trade receivables (b) Options (c) Shares (when held as an investment

Question 7

Examples of financial liabilities include:

Answer 7

(a) Trade payables (b) Debenture loans payable (c) Redeemable preference (non-equity) shares

Question 8

IAS 32 makes it clear that the following items are not financial instruments.

Answer 8

(a) Physical assets, eg inventories, property, plant and equipment, leased assets and intangible assets (patents, trademarks etc) (b) Prepaid expenses, deferred revenue and most warranty obligations (c) Liabilities or assets that are not contractual in nature

Question 9

Define Physical assets

Answer 9

control of these creates an opportunity to generate an inflow of cash or other assets, but it does not give rise to a present right to receive cash or other financial assets.

Question 10

Define Prepaid expense

Answer 10

the future economic benefit is the receipt of goods/services rather than the right to receive cash or other financial assets.

Question 11

Define Contingent rights and obligations

Answer 11

meet the definition of financial assets and financial liabilities respectively, even though many do not qualify for recognition in financial statements. This is because the contractual rights or obligations exist because of a past transaction or event (eg assumption of a guarantee).

Question 12

The main principle of IAS 32 is that financial instruments should be presented according to their____In particular, entities which issue financial instruments should classify them (or their component parts) as either financial liabilities, or equity

Answer 12

The main principle of IAS 32 is that financial instruments should be presented according to their substance, not merely their legal form. In particular, entities which issue financial instruments should classify them (or their component parts) as either financial liabilities, or equity

Question 13

The classification of a financial instrument as a liability or as equity depends on the following

Answer 13

 The substance of the contractual arrangement on initial recognition  The definitions of a financial liability and an equity instrument

Question 14

convertible debt is economically equivalent to

Answer 14

This is the economic equivalent of the issue of conventional debt plus a warrant to acquire shares in the future.

Question 15

in theory there are several possible ways of calculating the split, IAS 32 requires the following method for calculating the convertible debt:

Answer 15

(a) Calculate the value for the liability component. (b) Deduct this from the instrument as a whole to leave a residual value for the equity component.
The sum of the carrying amounts assigned to liability and equity will always be equal to the carrying amount that would be ascribed to the instrument as a whole.

Question 16

As well as looking at presentation in the statement of financial position, IAS 32 considers how financial instruments affect the statement of profit or loss and other comprehensive income (and changes in equity). The treatment varies according to whether interest, dividends, losses or gains relate to a financial liability or an equity instrument.

Answer 16

(a) Interest, dividends, losses and gains relating to a financial instrument (or component part) classified as a financial liability should be recognised as income or expense in profit or loss. (b) Distributions to holders of a financial instrument classified as an equity instrument (dividends to ordinary shareholders) should be debited directly to equity by the issuer. These will appear in the statement of changes in equity. (c) Transaction costs of an equity transaction should be accounted for as a deduction from equity, usually debited to the share premium account.

Question 17

FRS 7 replaces the disclosure requirements which were previously in IAS __

Answer 17

FRS 7 replaces the disclosure requirements which were previously in IAS 32

Question 18

WHAT ARE THE THINGS WHICH ARE ENCOUNRAGED IN DISCLOSURE IN IFRS 7

Answer 18

narrative commentary by issuers is encouraged by the Standard. This will enable users to understand management’s attitude to risk, whatever the current transactions involving financial instruments are at the period end. The standard does not prescribe the format or location for disclosure of information. A combination of narrative descriptions and specific quantified data should be given, as appropriate. The level of detail required is a matter of judgement. Where a large number of very similar financial instrument transactions are undertaken, these may be grouped together. Conversely, a single significant transaction may require full disclosure. Classes of instruments will be grouped together by management in a manner appropriate to the information to be disclosed.

Question 19

What does IFRS 9 apply to?

Answer 19

IFRS 9 applies to all entities and to all types of financial instruments except those specifically excluded, for example investments in subsidiaries, associates, joint ventures and other joint arrangements.

Question 20

Derecognition is the removal of a previously recognised financial instrument from an entity’s statement of financial position. An entity should derecognise a financial asset when:

Answer 20

(a) The contractual rights to the cash flows from the financial asset expire; or (b) It transfers substantially all the risks and rewards of ownership of the financial asset to another party.

Question 21

An entity should derecognise a financial liability when it is extinguished – ie when the obligation specified in the contract is discharged or cancelled or expires. It is possible for only part of a financial asset or liability to be derecognised. This is allowed if the part comprises:

Answer 21

(a) Only specifically identified cash flows; or (b) Only a fully proportionate (pro rata) share of the total cash flows.

Question 22

Classification of financial assets On recognition, IFRS 9 requires that financial assets are classified as measured at either

Answer 22

 Amortised cost  Fair value through other comprehensive income; or  Fair value through profit or loss

Question 23

Classification basis The IFRS 9 classification is made on the basis of both:

Answer 23

a) The entity’s business model for managing the financial assets, and (b) The contractual cash flow characteristics of the financial asset.

Question 24

A financial asset is classified as measured at amortised cost where:

Answer 24

(a) The objective of the business model within which the asset is held is to hold assets in order to collect contractual cash flows (b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal outstanding

Question 25

A financial asset must be classified as measured at fair value through other comprehensive income (unless designated at inception as measured at fair value through profit or loss) where:

Answer 25

(a) The objective of the business model within which the asset is held is achieved by both collecting contractual cash flows and selling financial assets; and (b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest.

Question 26

A debt instrument may be classified as measured at either __ cost or fair value depending on whether it meets the criteria above. Even where the criteria are met at initial recognition, a debt instrument may in certain circumstances be classified as measured at fair value through profit or loss.

Answer 26

A debt instrument may be classified as measured at either amortised cost or fair value depending on whether it meets the criteria above. Even where the criteria are met at initial recognition, a debt instrument may in certain circumstances be classified as measured at fair value through profit or loss.

Question 27

IFRS 9 allows debt instruments that pass the cash flow test for measurement at ___cost but are also held for trading to be carried at fair value through other comprehensive income

Answer 27

IFRS 9 allows debt instruments that pass the cash flow test for measurement at amortised cost but are also held for trading to be carried at fair value through other comprehensive income

Question 28

IFRS 9 introduces a business model test that requires an entity to assess whether its business objective for a debt instrument is to collect the contractual cash flows of the instrument as opposed to realising any change in its fair value by selling it prior to its contractual maturity. Note the following key points:

Answer 28

a) The assessment of a ‘business model’ is not made at an individual financial instrument level. (b) The assessment is based on how key management personnel actually manage the business, rather than management’s intentions for specific financial assets. (c) An entity may have more than one business model for managing its financial assets and the classification need not be determined at the reporting entity level. For example, it may have one portfolio of investments that it manages with the objective of collecting contractual cash flows and another portfolio of investments held with the objective of trading to realise changes in fair value. It would be appropriate for entities like these to carry out the assessment for classification purposes at portfolio level, rather than at entity level. (d) Although the objective of an entity’s business model may be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those assets until maturity. Thus an entity’s business model can be to hold financial assets to collect contractual cash flows even when sales of financial assets occur.

Question 29

The requirement in IFRS 9 to assess the non-contractual cash flow characteristics of a financial asset is based on the concept that only instruments with non-contractual cash flows of principal and interest on principal may qualify for amortised cost measurement. true/ false

Answer 29

The requirement in IFRS 9 to assess the contractual cash flow characteristics of a financial asset is based on the concept that only instruments with contractual cash flows of principal and interest on principal may qualify for amortised cost measurement.

Question 30

Summary of indications of appropriate treatment The following is a summary of indicators of the appropriate treatment. Indications that the debts are not an asset of the seller & Indications that the debts are an asset of the seller

Answer 30

Indications that the debts are not an asset of the seller:Transfer is for a single non-returnable fixed sum.
Indications that the debts are an asset of the seller: Finance cost varies with speed of collection of debts, eg:  By adjustment to consideration for original transfer, or  Subsequent transfers priced to recover costs of earlier transfers.

Question 31

Summary of indications of appropriate treatment The following is a summary of indicators of the appropriate treatment. Indications that the debts are not an asset of the seller & Indications that the debts are an asset of the seller

Answer 31

Indications that the debts are not an asset of the seller:There is no recourse to the seller for losses .Factor is paid all amounts received from the factored debts (and no more). Seller has no rights to further sums from the factor.
Indications that the debts are an asset of the seller:There is full recourse to the seller for losses.
Seller is required to repay amounts received from the factor on or before a set date, regardless of timing or amounts of collections from debtors.

Question 32

Receivables can be factored with recourse) or without recourse. Define recourse and non recourse

Answer 32

with recourse (significant benefits and risks retained)
 without recourse (benefits and risks not retained).

Question 33

. IFRS 9 requires that when an entity changes its business model for managing financial assets, it should reclassify all affected financial assets. This reclassification applies only to debt instruments, as equity instruments must be classified as measured at fair value. true/ false

Answer 33

true

Question 34

On recognition, IFRS 9 requires that financial liabilities are classified as measured either:

Answer 34

(a) At fair value through profit or loss, or (b) At amortised cost

Question 35

A financial liability is classified at fair value through profit or loss if:

Answer 35

(a) It is held for trading, or (b) Upon initial recognition it is designated at fair value through profit or loss

Question 36

Under IFRS 9 all financial assets should be initially measured at cost = fair value plus transaction costs. Financial liabilities should be measured at transaction price ie fair value of the consideration received. True/ False

Answer 36

Under IFRS 9 all financial assets should be initially measured at cost = fair value plus transaction costs. Financial liabilities should be measured at transaction price ie fair value of the consideration received.

Question 37

Subsequent measurement of financial assets – debt instruments After initial recognition, IFRS 9 requires an entity to measure financial assets at either amortised cost, fair value through other comprehensive income or fair value through profit or loss based on:

Answer 37

(a) The entity’s business model for managing the financial assets (b) The contractual cash flow characteristics of the financial asset

Question 38

A financial asset is measured at amortised cost if both of the following conditions are met

Answer 38

(a) The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows. (b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Question 39

After initial recognition, all financial assets other than those held at fair value through profit or loss should be remeasured to either fair value or amortised cost.
True/ false

Answer 39

After initial recognition, all financial assets other than those held at fair value through profit or loss should be remeasured to either fair value or amortised cost.

Question 40

a financial asset or liability at fair value through profit or loss meets either of the following conditions

Answer 40

(a) It is classified as held for trading. A financial instrument is classified as held for trading if it is: (i) Acquired or incurred principally for the purpose of selling or repurchasing it in the near term
(ii) Part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking (b) Upon initial recognition it is designated by the entity as at fair value through profit or loss.

Question 41

Assets held at amortised cost are measured using the effective interest method. true/ False

Answer 41

Assets held at amortised cost are measured using the effective interest method.

Question 42

Define Amortised cost of a financial asset or financial liability
Define effective interest method
Define effective interest rate

Answer 42

Amortised cost of a financial asset or financial liability is the amount at which the financial asset or liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation of any difference between that initial amount and the maturity amount, and minus any writedown for impairment or uncollectability. The effective interest method is a method of calculating the amortised cost of a financial instrument and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount.

Question 43

Equity instruments After initial recognition equity instruments are measured at either fair value through profit or loss (FVTPL) or fair value through other comprehensive income (FVTOCI). If equity instruments are held at FVTPL no transaction costs are included in the carrying amount. Equity instruments can be held at FVTOCI if:

Answer 43

(a) They are not held for trading (ie the intention is to hold them for the long term to collect dividend income) (b) An irrevocable election is made at initial recognition to measure the investment at FVTOCI If the investment is held at FVTOCI, all changes in fair value go through other comprehensive income. Only dividend income will appear in profit or loss.

Question 44

Own credit IFRS 9 requires that financial liabilities which are designated as measured at fair value through profit or loss are treated differently. In this case the gain or loss in a period must be classified into

Answer 44

 Gain or loss resulting from credit risk, and  Other gain or loss.

Question 45

Changes in a financial liability’s credit risk affect the fair value of that financial liability. This means that when an entity’s creditworthiness deteriorates, the fair value of its issued debt will decrease (and vice versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to be recognised in profit or loss for the year. true/ false

Answer 45

Changes in a financial liability’s credit risk affect the fair value of that financial liability. This means that when an entity’s creditworthiness deteriorates, the fair value of its issued debt will decrease (and vice versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to be recognised in profit or loss for the year

Question 46

Financial assets held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets must be measured at fair value with gains and losses recognised in other comprehensive income. True/ False

Answer 46

Financial assets held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets must be measured at fair value with gains and losses recognised in other comprehensive income.

Question 47

Financial instruments carried at amortised cost: gains and losses are recognised in profit or loss as a result of the amortisation process and when the asset is derecognised. True/ False

Answer 47

Financial instruments carried at amortised cost: gains and losses are recognised in profit or loss as a result of the amortisation process and when the asset is derecognised.

Question 48

The new impairment model in IFRS 9 is based on providing for expected losses (rather than dealing with losses after they have arisen) and applies to financial assets held at amortised cost and FVTOCI. The financial statements should reflect the general pattern of deterioration or improvement in the credit quality of financial instruments. True/ False

Answer 48

The new impairment model in IFRS 9 is based on providing for expected losses (rather than dealing with losses after they have arisen) and applies to financial assets held at amortised cost and FVTOCI. The financial statements should reflect the general pattern of deterioration or improvement in the credit quality of financial instruments.

Question 49

On initial recognition of the asset the entity creates a credit loss allowance equal to 12 months’ expected credit losses. This is calculated by multiplying the probability of a default occurring in the next 12 months by the expected credit losses that would result from that default. True/ False

Answer 49

On initial recognition of the asset the entity creates a credit loss allowance equal to 12 months’ expected credit losses. This is calculated by multiplying the probability of a default occurring in the next 12 months by the expected credit losses that would result from that default

Question 50

Financial assets carried at fair value through profit or loss On financial assets carried at fair value gains and losses are recognised in profit or loss. Any impairment loss should be recognised in net profit or loss for the year even though the financial asset has not been derecognised. True/ False

Answer 50

Financial assets carried at fair value through profit or loss On financial assets carried at fair value gains and losses are recognised in profit or loss. Any impairment loss should be recognised in net profit or loss for the year even though the financial asset has not been derecognised

Question 51

The impairment loss is the difference between its acquisition cost (net of any principal repayment and amortisation) and current fair value (for equity instruments) or recoverable amount (for debt instruments), less any impairment loss on that asset previously recognised in profit or loss True/ False

Answer 51

The impairment loss is the difference between its acquisition cost (net of any principal repayment and amortisation) and current fair value (for equity instruments) or recoverable amount (for debt instruments), less any impairment loss on that asset previously recognised in profit or loss

Question 52

Which issues are dealt with by IAS 32?

Answer 52

Classification between liabilities and equity; presentation

Question 53

What is the critical feature used to identify a financial liability?

Answer 53

The contractual obligation to deliver cash or another financial asset to the holder

Question 54

How should compound instruments be classified by the issuer?

Answer 54

By calculating the present value of the liability component and then deducting this from the instrument as a whole to leave a residual value for the equity component

Question 55

How are financial instruments initially measured?

Answer 55

At fair value plus transaction costs

Question 56

Where should redeemable preference shares appear in the statement of financial position?

Answer 56

Under non-current liabilities (not equity)

Question 57

When should a financial asset be de-recognised?

Answer 57

Financial assets should be derecognised when the rights to the cash flows from the asset expire or where substantially all the risks and rewards of ownership are transferred to another party.