Financial Instruments Flashcards
what is a financial instrument - financial asset, liability and equity instruments
This is a contract that creates a financial asset in one entity and a financial liability or equity instrument in another entity
Fin assets include cash, trade, receivables, investments in shares and loans
fin liabilities include trade payables and loans and equity instruments include ordinary share capital issued
Debt or Equity - initial recognition & subsequent recognition, F.V P&L, Equity
Equity
Initial recognition - FV less issue costs same for debt
when dividends are paid it is deducted from retained earnings
Debt
Debt is accounted for at amortised costs at default
initial recognition - fair value less issue costs
Finance costs increase and payments reduce.
Effective rate is finance cost. (P&L)
Coupon rate is payment - Cashflow
Liability can also be carried at FV through P&L
Only if carried for trading purposes
To avoid accounting mismatch e.g. where loan has been taken out to finance an asset at FV
Initial recognition is FV
Any difference between FV and amortised cost goes through P&L.
Effective rate and coupon rate stay on original amortised cost not FV
Gains and losses on remeasurement to FV are recognised in P&L unless they due to changes on entity’s own credit risk then OCI.
Consequences of classification - Debt or equity.
Is the transaction debt or equity?
Debt
1. Gearing goes up through finance cost
Equity
1. Gearing goes down
2. Dividends are not expenses
3. Equity dilutes existing shareholders.
Transaction must be recorded according to economic reality not legal form
Debt is an obligation and equity is evidence of ownership
1.is there obligation to pay dividends
2. does company have call option or shareholders have put option
3. PUT option creates an obligation
4. If equity is actually Debt, it should be classed as NCL and finance cost recognised for.
5. Fixed number of shares for fixed amount is equity
6. Debt is fixed term Equity is of a more permanent nature.
7. Is dividend non discretionary
Exam focus
1. Classification
2. Initial measurement
3. Subsequent measurement
4. De-recognition - Extinguished, discharged, cancelled or expired
Split Equity Accounting
Convertible loan notes - Definition, accounting treatment, initial recognition, debt and equity element, steps
CLN are debt that gives the holder the option to convert to equity.
SEA is splitting an instrument into a debt and equity component.
Compound instrument that proceeds need to be split into debt and equity elements
Initial recognition
DR CASH
CR NCL - PV of FCF
CR OCE - Balancing figure
- Split the elements
First year - debt element discounted to first year
second and final year - balance + first year original payment discounted to second year
Total amount of debt goes into first year liability calculation.
Equity is the balancing figure in the second year. - calculate the yearly amortised costs - opening balance, cashflow, finance cost, closing balance.
Financial assets - Introduction, types, classification
These include trade receivables, loans (as a lender, investments in equities and bonds.
Classifications
1. Amortised cost
2. FVTOCI
3. FVTPL - Default
How to decide which bucket to classify the asset
1. The cashflow test SPPI - The cashflow test is met if the cashflows are SOLELY the PAYMENTS of PRINCIPAL and INTEREST on the amount outstanding.
Are cashflows fixed or contractual
If SPPI is not met, financial asset is an equity instrument. Holder is an investor and owns share in a business.
Investments must be at FAIR VALUE
Default = FVTPL
can be FVTOCI (If at initial recognition and this is an irrevocable decision)
If the SPPI test is met, financial asset is a debt instrument, holder is a lender and is owed cash.
1. If business model is to keep forever and to collect cashflow, it should classified as AMMORTISED COST i.e. mortgage company
2. If asset may be sold in the future, it should be classified as FVTOCI on balance sheet, gain does not go through P&L because asset may not be sold.
3. If OTHER business mode i.e. Trading is at FVTPL
Financial Assets - Initial measurement, transaction costs, subsequent measurements
Exam question O’Driscoll
Amortised costs - Transaction costs are capitalised
FVTOCI - Transaction costs are capitalised
FVTPL - Transaction costs are expensed
Subsequent measurement of financial assets
1. Amortised costs - Amortised cost
2. FVTOCI - FVTOCI
3. FVTPL
Initial recognition of asset X
Finance Income X
less : cash paid (X)
First year balance
P&L effective rate is per amortised cost not F.V amount
Reclassification of financial assets
1. Liabilities can never be reclassified
2. Equity classification is irrevocable
3. Reclassification is only allowed if there is a change of business model.
4. Reclassification is done on a forward looking basis, previously recognised gains cannot be restated. when contractual cashflow from assets expire.
Derecognition
This happens when all the risks and rewards of ownership have been transferred.
Exam focus
1. Does it meet the cash flow test
2. what is the business model
3. what is the initial recognition - Transaction costs?
Impairment of financial assets - Intro, definition, scope, stages
what is the ECL?
Expected credit losses model
1. Forward looking model
2. very prudent as losses have not yet occurred.
3. It is a subjective.
4. charge to P&L
ECL is the cash shortfall on the future cashflow on financial assets.
It is the difference between the contractual cashflows and the cashflows an entity expects to receive discounted at the original effective interest rate.
The amount an entity expects to receive is the weighted average of credit losses with the respective risk of default occurring as the weights.
Scope - Assets held forever and you may or may not sell
1. Financial assets measured at amortised cost
2. FVTOCI debt instrument
3. lease and trade receivables
Impairment of financial assets - stages, ECL, Elements
Stage 1 - Initial recognition
when asset is purchased or originated, you must recognise ECL 12 months into the future (maybe Nil)
Interest income is calculated on gross carrying amount
Stage 2 - Annual review
If the credit risk is similar, continue with ECL - movement is posted to P&L and allowance is increased on B/S
If the credit risk has increased then recognise ECL on a lifetime basis
If the company is in trouble and there’s reason to believe they are likely to default. e.g. late payment, industry issues, credit crunch. - ECL on a lifetime basis - DR expense, CR allowance
Interest income is calculated on gross carrying amount
Stage 3 - Objective evidence of impairment exists at the reporting date
Recognise ECL on lifetime basis
Absolute certainty things are going wrong, evidence of credit risk
Debt instrument will be impaired
Interest income is calculated on Net carrying amount
what is contractual cashflows
what are the expected cashflows
what’s the difference
Discount the difference yearly
cashflow element, capital element - If debt instrument is not credit impaired capital is intact.
If Buying or originating junk or credit impaired assets, Lifetime ECL must be considered.
when you buy own shares - DR cash CR treasury shares
No gain or loss can be recognised on the sale, issue or cancellation of entity’s equity instrument
No economic benefit can be recognised so no assets.
Investment in treasury shares is deducted from equity.
Accounting for derivatives - Definition, Reasons for holding derivatives, Lifecyle, classification, default classification and accounting,
Examples includes Forward contracts, futures, swaps, options
A derivative is a financial instrument entered into at no initial cost and designed to be settled at a future date. The value changes in response to a change in the underlying item. The derivative derives price from price and change in price of underlying item.
Lifecycle
1. Classification - Hedge or default (speculation)
2. Initial measurement
3. Subsequent measurement
4. Derecognition
Reasons for holding derivatives
1. Speculative reasons
2.Hedging reasons - to offset a risk
classification
It is important to document why you entered into a derivative contract, default is SPECULATION
To be classified as a hedge, it has to be documented in line with policy.
Accounting treatment is gains and losses go through P&L (FVTPL)
They are remeasured at each reporting date and gain/loss is posted to P&L.
Hedge accounting - Hedging criteria, Types, Accounting
Hedging
Hedging is a strategy to reduce risk.
Criteria for classifying derivative as a hedge
1. Formal designation and policy
2. Effective hedge
Types of Hedging
1.Fair value hedge - Gain or loss is in financial statements i.e. monetary assets, the accounting is FVTPL to offset gain or loss in financial statement
2. Cashflow hedging - This is on a future cashflow or future commitments the accounting is recognised in equity (OCI), it is parked until a future time when the hedge occurs and it is then recycled.
If it is an ineffective element, that goes to P&L
It is derecognised when it ceases to be a hedge e.g. hedged item or instrument no longer exists or is sold.
F.V hedge goes to P&L.
Cashflow hedge - If the transaction is no longer expected to occur profit or loss in Equity is reclassified if transaction is still expected to occur amount previously recognised in OCI remains in equity until expected transaction occurs and is then reclassified.
Accounting for derivatives - initial measurement, Subsequent measurement, Change in FV
Initial measurement - Nil
Subsequent measurement - F.V
Historical cost model cannot be used as cost is Nil so not faithful representation.
All derivatives must be measured at FV at each reporting date
Change in FV
Intention for holding derivative must be considered to achieve matching
The FV movement is posted to Equity for PPE and P&L for investment property.
PPE is held for use in the business whilst Investment property is held for capital appreciation.
