Chapter 6 Financial instruments Flashcards
1.1 Financial instruments introduction
There are three accounting standards that deal with financial instruments: IAS 32 (deals with classification of financial instruments and their presentation in the financial statements), IFRS 9 (deals with how instruments are measured and when they should be recognised) and IFRS 7 (deals with disclosure of financial instruments in the accounts).
2.1 IAS 32 Financial instruments presentation
IAS 32 defines a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. A financial asset is any asset that is cash, an equity instrument of another entity or a contractual right to receive cash or another financial asset from another entity or to exchange financial assets or liabilities with another entity under conditions that are potentially favourable to the entity.
A financial liability is any liability that is a contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or liabilities with another entity under conditions that are potentially unfavourable to the entity.
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
2.2 Presentation of liabilities and equity
According to IAS 32 the issuer of a financial instrument must classify is as a financial liability, asset, or equity instrument on initial recognition according to its substance. If the instrument meets the definition of a financial liability, then it should be presented as such, regardless of its legal form. Therefore, redeemable preference shares are classified as liabilities and irredeemable preference shares are classed as equity (unless there is an obligation to pay a dividend, then treated as a financial liability). Classification is made at the date of issue and should not be changed.
2.3 Interest, dividends, losses, and gains
The accounting treatment follows the treatment of the instrument itself. Therefore, redeemable preference share dividends are finance costs in the P+L. Irredeemable preference share dividends are taken through RE in SOCIE unless there is a mandatory obligation to pay the dividend and then it is treated as a finance cost.
3.1 Initial recognition
All financial assets initially recognised as their fair value. This is usually adjusted for the transaction costs by adding them on. For financial liabilities an adjustment is made for transaction costs by deducting them. IFRS 13 defines FV as 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.
3.2 Subsequent treatment
In the exam all financial assets and liabilities will be measured at amortised cost using the effective interest rate method. The effective rate spreads all of the costs of the liability (transaction fees, issue discounts, annual interest payments and redemption premiums) to the P+L over the term of the instrument. The coupon rate is the amount of interest paid (always given as a percentage of the nominal value).
4.1 Compound instruments
A compound instrument has characteristics of both equity and a liability, for example a convertible bond. IAS 32 required them to use a split accounting at the date of issue. A liability is an obligation to pay annual interest and capital, calculate PV of future cash flows using interest rate of equivalent bond with no conversion option as discount rate. Equity is option to convert to shares. The equity element is the total value of the bond less the liability element.
The liability and equity must be shown separately in the accounts. The liability element will be held under amortised cost per IFRS 9. The equity element will not change.
5.1 Treasury shares
When companies acquire their own shares as an alternative to making dividend distributions and/or as a way to return excess capital to shareholders. The treatment of treasury shares is:
- Should be deducted from equity
- No gain or loss should be recognised on their purchase
- Consideration paid or received should be recognised directly in equity
Treasury shares can either be disclosed on the face of the SPF or in the notes.
6.1 IFRS 7 Financial instrument disclosures
Main categories of disclosure are information about the significance of the instrument and information on the nature and extent of risks arising from the instrument and how the risks are managed.
- Quantitative disclosures: entity discloses the carrying value of each class of instrument. The fair value of each class is also disclosed
- Qualitative disclosures: entity discloses information to enable users to understand managements attitude to risk. Disclosures focus on the entity’s credit risk, liquidity risk and market risk
