Semester 2 Week 2 Tutorial 1 Flashcards
Briefly define what a financial instrument is.
A financial instrument is a transaction which leads to a financial asset in one party and a financial liability or an equity instrument in another.
Briefly define what a financial asset is.
A financial asset is cash, an equity instrument in another business, the right to receive cash (or similar) from another business, or the right to swap financial instruments on favourable terms.
Briefly define what financial liability is.
A financial liability is the obligation to deliver cash to another party or swap financial instruments on unfavourable terms.
Honlux Plc. has acquitted the right to buy $14,000,000 at an exchange rate of $1.80:£1 in July 2024. The arrangement cost nothing to buy but there were setup fees of £2,000. State what kind of instrument this is and give its characteristics.
This is a derivative as i) it changes in value with an economic underlying (currency), ii) it settles in the future (July 2024) iii) it costs very little to setup in relation to the final settlement amount.
- For each of the following state whether they would be debt or equity and why:
a. Hawes has issued 4,000,000 £1 5% 2023 bonds.
b. Whittington has issued 2,000,000 50p ordinary shares.
c. Madden has issued 1,000,000 50p preference shares. These preference shares must pay out an annual dividend of 3p per share.
d. Walker has issued 3,000,000 £1 preference shares. The dividend is at the discretion of the directors but must be paid out before any ordinary dividend can be paid.
a. This is debt the bonds carry with them an obligation to pay a set amount each year as well as the principal on maturity.
b. This is equity ordinary shares have no requirement to pay out any amount in dividends.
c. This is debt the preference shares have a requirement that a certain amount is paid each year.
d. This is equity – there is no obligation for any amount to be paid out in preference dividends.
- For each of the following state what class of asset they would belong to and why:
a. Bresland has purchased 1,000,000 ordinary £1 shares in Courland Plc.
b. Gudrun has purchased 6,000,000 25p bonds in Cooper Plc. Gudrun intends to keep these bonds until maturity.
c. Northcote Ltd. has purchased £3,000,000 of Government Bonds from the Central Bank of East Krugland. Northcote operates in a seasonal environment and uses these bonds to manage liquidity.
d. Due to the economic downturn Marco has had the opportunity to purchase mortgages with a value of £2,500,000 from the New Bradford Bank. Marco does not intend to hold these mortgages to maturity but instead to sell them when the market matures.
e. Copman Ltd. has purchased 1,500,000 shares in Nadia Plc. Copman has made an election to classify these as Fair Value through Other Comprehensive Income (FVTOCI).
a. This would be FVTPL the shares have no cashflows of interest and capital.
b. As these bonds have cashflows fully consisting of interest and capital and Goodrun intends to hold them to maturity they would be amortised cost.
c. As these bonds have been acquired to manage liquidity they would be FVTOCI (debt).
d. Although the mortgages have cashflows consisting of interest and capital they are not intended to be held to maturity but instead held in the short term. They would therefore be classed as FVTPL.
e. Although these shares would normally be FVTPL the fact that an election has been made they would be classified as FVTOCI (equity).
Gamrat Plc. issues 2,000,000 £1 7.5% bonds on 1 January 20X1. Interest is paid on the 31st December each year and £2,400,000 will be repaid on 31 December 20X3 (i.e. the £2,000,000 amount borrowed plus a £400,000 bonus payment to bondholders). This equates to an effective interest rate of approximately 13.351%.
Prepare journal entries for each year from the issue of the bonds on 1 January 20X1 to their repayment on 31 December 20X3.
20X1
Dr bank 2,000,000
Cr bond liability 2,000,000
Being issue of bonds
Annual interest = 13.351% x 2,000,000 = 267,020
Dr P/L interest expense 267,020
Cr bond liability 267,020
Being year 1 interest expense
Nominal interest = 7.5% x 2,000,000 = 150,000
Dr bond liability 150,000
Cr bank 150,000
Being interest paid year 1
Balance at end of 20X1 = 2,000,000 + 267,020 – 150,000 = 2,117,020
20X2
Annual interest = 13.351% x 2,117,020 = 282,643
Dr P/L interest expense 282,643
Cr bond liability 282,643
Being year 2 interest expense
Nominal interest = 7.5% x 2,000,000 = 150,000
Dr bond liability 150,000
Cr bank 150,000
Being interest paid year 2
Balance at end of 20X2 = 2,117,020 + 282,643 – 150,000 = 2,249,662
20X3
Annual interest = 13.351% x 2,249,662 = 300,338 (rounded)
Dr P/L interest expense 300,338
Cr bond liability 300,338
Being year 3 interest expense
Nominal interest = 7.5% x 2,000,000 = 150,000
Dr bond liability 150,000
Cr bank 150,000
Being interest paid year 3
Balance at end of 20X3 = 2,249,662+300,338 – 150,000 = 2,400,000
Dr bond liability 2,400,000
Cr bank 2,400,000
Being repayment of bonds
