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Prepared by John Andrews aka Paddingtonbear Financial Instruments (FI) : Financial Assets (FA) & Financial Liabilities (FL) ACCA. Student Accountant. Article. December 2008. Page 48 - 53. Financial Instruments. Tom Clendon IAS 32 F.I. Presentation IAS 39 F.I. Recognition & Measurement IFRS 7 F.I. Disclosure http://www.iasplus.com/standard/ias32.htm http://www.iasplus.com/standard/ias39.htm http://www.iasplus.com/standard/ifrs07.htm ------------------------------------------------------------------------------------------------------------------------------------------------------ FI FA FL Equity - Capital Debt - Capital Convertible Bond Redeemable Preference Share Categories of FA H. A. L. F Category of asset Description / features H eld to Maturity Fixed payments & maturity that the entity has intention and ability to hold until maturity Valued at amortised cost using effective ir Hold a fixed interest or fixed term bond for whole of it’s life A vailable for sale Any FA designated as such or not fitting into any other FA category Valued at FV Changes in FV recognised in ST of Equity - OCI Dividends recognised in SoCI Long term investment in equity shares L oans & Receivables Created by the entity by providing goods, services, money direct to a debtor Measured at amortised cost Trade debtors F V through SoCI Derivatives & FA held/acquired for selling in the short term After Initial recognition Measure at FV Changes in FV recognised in SoCI Equity investment held in the short term for trading FV is the amount an asset could be exchanged, liability settled, between knowledgeable, willing parties in arms length transaction Accounting treatment example Derivative held for speculation This is a complex area so the examiner has limited himself to 3 possible topics . . . and said he will never complicate these issues beyond the descriptions below : 1). Distinguishing Equity & Debt : Debt contract rights to repayment & Interest . . incl redeemable pref shares Equity does NOT have a this contractual obligation. . . but has voting rights 2). Accounting for Assets at FV : Assets at FV are carried at FV . . Gains / losses go to SoCI 3). Convertible Debt : Slightly complicated . . Examiner expects you to split loan between debt & equity and unwind the debt (example ?) --------------------------------------------------------------------------------------------------------------------------------------------------Kaplan tutor said, “in exam you will need to know the following” : 1) Definitions 2) Measurement . . What to record in SoFP & SoCI 3) Difference between a FL and FA -------------------------------------------------------------------------------------------------------------------------------------------------- Definitions : FI FA FL FI = contract that gives rise to FA in one entity and a FL or equity instrument in another entity Company A Company B Asset liability / equity Bank . . Lends loan loan agreement takes loan from bank creates a debtor Creates a liability FA has 4 categories 2 debtor balances : split into 2 groups of asset types Cash 2 investment assets Contract that will / may be settled with entity own equity . . . Options A contractual right to receive cash or another financial asset from another entity . . Equity of another entity Shares Trade Receivables Measure debtors at amortised costs To match value of liability held by the other company FL measurement reason Mark to market SoFP reflects MV of investment Change in value . .Gains / loss . . Recognised in SoCI = any liability that is a contractual obligation to : Deliver cash or another FA to another entity . . . . . . . . . . . . . . . . . . . . . . Trade Payables Exchange FA /FL with another entity under unfavourable conditions . . . . .Debenture loans ?? Contract that may be settled in entities own equity . . . . . . . . . . . . . . . . . Redeemable preference shares e.g. Redeemable preference shares . . to raise finance . . to finance projects . . Fixed dividend paid yearly . . initial loan repaid at agreed future date . . Show as loan Substance Over Form principle . . in substance this is a loan . . not equity (commercial substance of FI may differ from it’s strict legal form . . . some FI takes legal form of equity and others liability . . . . Other FI combine features of equity and liability) . . . i.e. compound instrument A company will argue that a convertible should be reflected as equity because of the likely hood of it being converted at term end . . . this of coarse affects ratios and disclosure favourably . . . Manipulation . . . .off balance sheet finance . . . financial structure, D/E gearing ratio and caveats IAS 32 & 39 does not allow this . . . Instead calculate FV of liability component by. . . . FV = PV of future cash flows from liability Assume loan will not be converted but repaid at PV of future cash flows . . PV requires DF based on ir that would be applied to similar liabilities = effective rate . . . (always higher rate in exam) Example : Compound Instrument ; A company issues 20,000 convertible bonds, with 3 year term, issued at par with face value of £100 each, total proceeds from issue £2m, nominal interest payable annually in arrears at 6%, prevailing market ir for similar debt without conversion is 9% . . . . . Show how FI will be split ? Initial recognition : Yr 1 2 3 cash flow (6%*32m) 120,000 120,000 2,120,000 DF 9% .917 .842 .772 (Balancing figure) Yr 1 2 3 initial recognition O/b 1,848,000 + 1,895,840 + 1,947,507 + finance cost - SoCI effective ir 8% 147,840 151,667 155,800 - PV 110,000 101,000 1,637,000 1,848,000 152,000 2,000,000 6% interest paid cash flows (100,000) (100,000) (100,000) Disclosure Debt CR SoFP Equity CR SoFP Cash DR bank Liability Equity initial cash inflow c/b 1,895,840 1,947,507 2,000,000 __________________________________________________________________________________________ Disclosure of Compound Instruments : Using above example : how would this convertible Bond look in the financial statements after the first year? SoFP - Capital Account - Equity SoFP - Long Term Liability - Creditor > 1 year £ 152,000 £ 1,895,840 SoCI - Finance Cost £ 147,840 Purpose of disclosure : IAS 32, IAS 39, IFRS 7, and substance over form principle : Provide information that will enhance understanding of the significance of on-balance-sheet and off-balancesheet FI to the entities overall financial position, performance and cash flows To help with assessing timing, amounts and certainty of future cash flows associated with those FI ----------------------------------------------------------------------------------------------------------------------------------------------------Amortisation : In the above example the convertible bond was amortised The finance cost for yr 1 of £147,840 = amount of amortisation . . obtained using effective ROI of 8% . . this is taken to SoCI as a finance charge for the year This amortisation amount is also added to initial recognition . . Which increases CV in the SoFP at end of yr 1 You can see from disclosure above the financial statement extracts . . . And how to treat these items 1). If we account for land at cost then CV will not change because historic cost does not change 2). For plant, which has a limited life, we can account for it using depreciated cost . . .although he asset is never revalued . . CV reduces each year reflecting depn charge 3). If we account for a liability using amortised cost then . . It has not been revalued . . But will increase each year by the effective rate of interest . . (DR as expense in SoCI - CR liability) this is reduced simultaneously by amount of nominal interest actually paid each year (Dr liability - CR cash) ----------------------------------------------------------------------------------------------------------------------------------- Exercise : which of the following are FI ? 1) inventories 2) investment in ordinary shares 3) prepayments for goods & services 4) liability for income tax 5) a share option 1) 2) 3) 4) 5) physical assets or NCA are not FI . . .there is no contractual right to receive cash or another FI is a FA because it is an equity instrument of another entity not FI because future economic benefit will be receipt of goods/services not an FA not a FI because obligation is statutory not contractual is a FI because a contractual obligation exists to deliver equity instrument ------------------------------------------------------------------------------------------------------------------------------------- Debt Instrument Amortised Costs : Debt is issued for £1,000. Redeemable at £1,250. Term of debt is 5 years. Interest is paid at 5.9%. Effective ir is 10% Required : show amounts charged to finance cost each year and amount to be recognised in SoCI Yr 1 2 3 4 5 open bal Cash rec’d 1000 1,041 1,086 1,136 1,191 10% ir effective + + + + + 100 104 108 114 119 545 - 5.9% payment made c/b (59) (59) (59) (59) (59) 1,041 1,086 1,136 1,191 1,250 £545 = Finance charges to SoCI _______________________________________________________________________________________ 01/10/2004 company issued 50,000 redeemable preference shares with par value £100 each to investors at £55. Redeemable on30/09/2009 with coupon rate of 2%. Effective ir 15.62% How would these appear in financial statements for years ending 30/09/2005 and 30/09/2006 ? Proceeds 50,000 * £55 = £2,750,000 Yr end o/b 30/09/2005 30/09/2006 2,750 3,080 Annual payments 50,000 * 2% = 3100,000 finance costs 15.62% 430 481 SoFP y/e 30/09/2005 Liabilities > 1 year - pref share 3,080 SoCI - Finance Charge 430 SoFP y/e 30/09/2006 Liabilities > 1 year - pref share 3,461 SoCI - Finance Charge 481 cash paid 2% (100) (100) c/b 3,080 3,461 _________________________________________________________________________________________