Semester 2 Week 1 PP (Financial Instruments)

Question 1

What is a financial instrument?

Answer 1

A financial instrument is a transaction which leads to a
Financial asset in one business
and
A financial liability OR equity instrument in another business.

Question 2

What is a financial asset?

Answer 2

A financial asset is:
1. Cash
2. An equity instrument in another business
3. The right to receive cash (or similar) from another business
4. The right to swap financial assets on favorable terms.

Common financial assets:
Cash
Debtors/accounts receivable
Bond investments
Share investments

Question 3

What are financial liabilities?

Answer 3

Financial liabilities are:
1. The obligation to deliver cash to another party.
2. The obligation to swap financial assets on unfavourable terms.

Common financial liabilities:
Bank overdrafts
Trade payables
Bank loans
Bonds issued

Question 4

What are equity instruments?

Answer 4

Equity instruments are
The remaining interest in a business after all liabilities have been settled.
Usually refers to shares.

Question 5

Pompeo Ltd. sell £25,000 worth of goods on credit to Lawrence Ltd.

Who has what financial instruments?

Answer 5

Pompeo have a financial asset (trade receivable of £25,000 – the right to receive cash).
Lawrence Ltd. have a financial liability (trade payable – the obligation to pay Pompeo the cash).

Question 6

Zebra Ltd. buy 1,000 shares in Lion Plc.

Who has what financial instruments?

Answer 6

Zebra have a financial asset – an equity instrument in another entity.
Lion have an equity instrument – Zebra have an entitlement to their assets after the payment of liabilities.

Question 7

What is the difference between Debt and Equity?

Answer 7

Financial liabilities have an element of obligation equity has no obligation.

Question 8

Guthrie Plc. has issued 600,000 £1 ordinary shares and 200,000 £1 10% bonds 2022.

Answer 8

With the shares there is no obligation to ever pay a dividend – as there is no obligation the shares are equity
With the bonds, however, there is an obligation to pay 10% interest each year plus the principal back in 2022 the bonds are a liability.

Question 9

Kelly Ltd. has 1,000,000 £1 preference shares. They are required to pay a dividend of 5p per share each year.
Daniela has 1,000,000 £1 preference shares. There is no fixed dividend, but the preference share dividend must be paid before any ordinary dividend can be paid.

Answer 9

Kelly is required to pay a certain amount each year – as there is an obligation these preference shares are therefore debt (a liability).
Daniela is not required to pay any amount – as there is no obligation these preference shares are equity.

Question 10

What are derivatives?

Answer 10

Derivatives are financial instruments which:
1. Vary in price according to an economic underlying (e.g. shares, oil, etc.).
2. Are settled at some point in the future.
3. The cost of the derivative is either zero or very small compared to the final settlement amount.
Options (which you may have encountered in your finance course(s) ) are types of derivative.

Question 11

Stuart Plc. enters into an agreement with a merchant bank to buy 1 million barrels of oil at $105 per barrel in one years time. The legal fees in setting up the deal were $1,000.

Answer 11

This is a derivative as:
1. Varies with an economic underlying (the price of oil will make this agreement more or less valuable)
2. Settles in the future (1 years time)
3.Cost ($1,000) very small compared to final settlement ($105,000,000).

Question 12

Are derivatives assets or liabilities?

Answer 12

Derivatives can be assets or liabilities.

It could give you the opportunity to buy something at below current market price (asset)
Or give you the obligation to buy something at above current market price (obligation).

Question 13

What are some non-financial instruments?

Answer 13

The following items are NOT financial instruments:
Lease liabilities
Pension assets/liabilities
Investments in subsidiary companies
A company’s own shares
This is because all of these have their own specific accounting standard dealing with them.

Question 14

What are different types of asset classes?

Answer 14

Amortised cost
Assets in this category have to:
Have cashflows purely consisting of interest and capital (i.e. no dividends or similar)
Be planned to help to maturity (i.e. not held for short term trading).

Fair Value Through P&L (FVTPL)
Anything not amortised cost will be FVTPL by default, so this includes:
Items without interest and capital cashflows (e.g. shares).
Items which are not being held to maturity

FVTPL means we hold them at fair (market) value taking any gains or losses through the P&L.

Two “additional” classes
Fair Value Through Other Comprehensive Income (equities)
(FVTOCI equities)
A company which has an equity investment (has bought shares in another company) it can make a decision called an election to classify this investment as FVTOCI rather than FVTPL. This means that although the shares will still be held at fair (market) value but that any gains and losses will the revaluation reserve (not the P&L). In the exam if a company has elected to classify equity investments as FVTOCI you would be told.
If the question mentions nothing they are FVTPL.
Decision made on an “investment by investment” basis so quite possible that some investments will be FVTPL and others FVTOCI (equity).

Fair Value Through Other Comprehensive Income (debt) (FVTOCI debt)
These are debt (bonds etc.) items which have been purchased specifically to help manage the company’s liquidity.
Treatment is a “half-way house” between FV and amortised cost. We do not cover the treatment further in this course.

Question 15

Asset Class Examples

4) 5,000 ordinary shares in Hubert Plc for £4.75 a share. An election has been made to classify these as FVTOCI.
5) In order to manage liquidity Peerless has purchased £1.4m of Government Bonds from the Central Bank of Abkazia.

Answer 15

4) FVTOCI (equities) – An equity investment (investment in shares) with an election made.
5) FVTOCI (debt) – An investment in debt held to manage liquidity.

Question 16

What are bonds?

Answer 16

A company receives money from investors (bondholders) in return they issue a document – saying they will pay back the principal sum borrowed on a certain date, plus interest in-between.

Also known as loan stock or debentures.

A company that has issued its own bonds has a liability.
A company that has bought bonds in another company as an investment has an asset.

Question 17

Vermouth Ltd. has lent £1m to its supplier Brandy Ltd.
Under the terms of the arrangement Brandy will pay interest of 5% of the capital balance each year for 5 years plus £1.4m at the end of 5 years.
What is the total return to Vermouth?

Answer 17

The return would the 5% each year for 5 years plus the additional £400,000 in the 5th year.
If we just recognised the £400,000 in the fifth year this would be against the accruals concept. We have lent the money for the full 5 years and we should therefore recognise the income evenly over the full 5 years.
How do we do this?

We use the effective rate of interest this is the total return averaged out over the lifetime of the instrument.

Question 18

Kyle Plc. has borrowed £500,000 for 10 years. The condition of the loan is that they will pay 8% interest on the principal balance for each year – plus the full £500,000 back after 10 years.

Is the actual interest and the effective interest different or the same?

Answer 18

As the only return/cost is the interest actual and effective interest will be the same at 8%.

Question 19

How do we calculate and treat amortised costs?

Answer 19

When an asset is held at amortised cost it is treated as follows:

Balance at year end = balance at year start + (effective interest rate x balance at year start) – cash received

Note: The effective interest rate x balance at year start gives the interest income for the year.
We only record the cash actually received. There is no accrual made.

For an amortised cost liability the treatment would be exactly the same except we would be dealing with interest expense and cash paid.

Essentially it would be the mirror image of the asset calculation.

Journals (asset)

Dr Investment asset
Cr Finance income
Being finance income recognised

Dr Bank
Cr Investment asset
Being cash received

Journals (liability)

Dr Finance cost
Cr Financial liability
Being finance cost recognised

Dr Financial liability
Cr Bank
Being cash paid

Question 20

On 1 January 20X1 Hemma Plc. issues £2,000,000 £1 6.5% bonds at a discount of 5%. The bonds will be repaid after 3 years. Interest is paid each year on 31 December.
The effective rate of interest is approximately 8.46%.

Showing workings prepare journals to account for the transaction from issue to repayment.

Answer 20

(Yr 1) 2,000,000 x 95% = 1,900,000

Dr Bank 1,900,000
Cr Bond liability 1,900,000
Being bond issue
NB: The effective interest rate takes into account that the bonds were issued at a discount. No further adjustment is required.

Finance cost = 8.46% x 1,900,000 = 160,667

Cash paid = 6.5% x 2,000,000 = 130,000
(note the cash paid is always based on the face value of the bonds and the nominal interest rate)

Balance at end year 1 = 1,900,000 + 160,667 – 130,000
= 1,930,667

Dr Finance cost 160,667
Cr Bond liability 160,667
Being finance cost recognised

Dr Bond liability 130,000
Cr Bank 130,000
Being cash paid

(Yr 2) Finance cost = 8.46% x 1,930,667 = 163,260

Cash paid = 6.5% x 2,000,000 = 130,000
(note the cash paid is always based on the face value of the bonds even in subsequent years

Balance at end year 2 = 1,930,667 + 163,260 – 130,000
= 1,963,927

Dr Finance cost 163,260
Cr Bond liability 160,260
Being finance cost recognised

Dr Bond liability 130,000
Cr Bank 130,000
Being cash paid

(Yr 3) Finance cost = 8.46% x 1,963,927 = 166,073

Cash paid = 6.5% x 2,000,000 = 130,000
(note the cash paid is always based on the face value of the bonds even in subsequent years)

Balance at end year 3 = 1,963,927 + 166,073 – 130,000
= 2,000,000

Dr Finance cost 166,073
Cr Bond liability 166,073
Being finance cost recognised

Dr Bond liability 130,000
Cr Bank 130,000
Being cash paid

Amount is repaid at the end of year 3

Dr Bond liability 2,000,000
Cr Bank 2,000,000
Being bonds repaid

Question 21

What asset class is a derivative?

Answer 21

Derivatives are all FVTPL unless used for hedging (not covered in second year).