Chapter 4 - Financial Instruments Flashcards
IAS 32 Defines a financial instrument to be?
Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument in another
Phoenix ltd buys 100,000 £1 ordinary shares in Cyclops. What are the two financial instruments?
Phoenix has a financial investment, thus a financial asset
Cyclops has issued the ordinary shares, resulting in equity
We recognise financial instruments based on their substance over
legal form
What would we classify both redeemable and irredeemable preference shares?
Redeemable - classify as a liability
Irredeemable - classify as equity, unless there is a mandatory obligation to pay back dividend
What are the accounting treatments for redeemable and irredeemable dividends
Redeemable - Finance cost in SPL
Irredeemable - Deduct from RE in SOCIE unless there is a mandatory requirement to pay, in which we would debit SPL as finance cost
All financial instruments are initially recognised at their FV. We adjust for transaction costs, which differs for FA and FL how?
FA = FV + transaction costs
FL = FV - transaction costs
In FAR exam, all FA and FL are measured at amortised cost using?
the effective interest rate.
Thus in order to get the amortisation (interest accumulated) we times FV by this
What is the difference between the effective rate of interest and the coupon rate?
Effective ROI = spreads all the costs of the liability to the SPL based on term of instrument
Coupon rate = amount of interest paid already
What are the steps for reaching the total c/f amortised cost
- b/f fair value (adjusting for any transaction costs)
- amortisation (interest) = b’f * effective ROR
- deduct any cash paid * coupon rate
- C/f = amortised cost
1 Jan X1 Flash issued £50,000 5% redeemable preference shares. Issue costs were £2000. Redeemable at a premium of £5613 in 3 years time. Effective ROI 10%.
How is this showed in fs for 31 Dec X1 and X2
Redeemable pref shares = liability due to dividend payments
31 Dec X1
b/f FV - transaction costs (£50,000- £2,000) = £48,000
amortisation - b/f * effective ROR (£48,000 * 10% = £4800)
cash paid * coupon (£50,000 * 5% = (£2500)
c/f total amortised cost = £48,000 + £4,800 - £2,500 = £50,300
Thus we could Dr Finance Cost £4800 (Note; if this was a FA we could Cr Finance Income)
Cr NCL £50,300 - Thus carried at amortised cost in the SFP
31 Dec X2
B/f £50,300
Amortisation (£50,300 * 10% = £5030)
Cash paid (£50,000 * 5% = (£2,500) - same for 3 years
c/f total amortised cost = £50,300 + £5030 - £2,500 = £52,830
Thus we could Dr Finance Cost £5030
Cr NCL £52,830
(Note in year 3 this would be a CL)
What is a compound instrument. What does IAS 32 require us to do with this
Characteristics of both equity and liability, e.g convertible bond
Required to implement split accounting
How does a convertible bond have 2 characteristics
A convertible bond is where an company issues a bond (as a way to raise finance, thus annual interest is paid to bond owner), but there is also an option to convert this bond into shares of the company
Liability in the fact that annual interest is obliged to be paid
Equity - can convert bond to shares
The liability and equity must be recognised separately in the SFP. Thus moving forward each period what would the different accounting treatments be
Liability element would be recognised on SFP at amortised cost year on year
Equity element does not change.
How do we calculate the liability side of a convertible bond?
Calculate the NPV of future cash flows, using the interest rate of an equivalent bond without a conversion option.
Craig issues 1000 £100 4% convertible loan notes on 1 Jan X6. Market rate of interest for similar instrument is 8%. How should this be accounted for. Redemption is at par on 31 Dec 20X8
Step 1 - Calculate NPV of future cash flows
31 Dec X6
Total loan note value = 1000 * £100 = £100,000. Annual cash flow is 4* = £4,000. We discount this with the market rate of interest of a similar instrument (8% therefore * times £4,000 by (1/1.08)^1 to get NPV of CF of £3,704
31 Dec X7
Same process as above, NPV of £4,000 but at a DF (1/1.08)^2 = £3,429
31 Dec X8
Annual cashflow is now £4000 + the original loan of £100,000. This is because this is redemption at par on 31 Dec X8, hence needs to be paid back. Total CF is £104,000 at a DF (1/1.08)^3 = £82,559
Total NPV of future cash flows = £3704 + £3249 + £82559 = £89,512.
Thus is our liability amount.
Given the total value of convertible loan note is £100,000, equity must be £10,308
Cr liability 89,512
Cr equity 10,308
Dr cash 100,000
