CHAPTER FOURTEEN - Financial Instruments

A Financial Instrument is

any contract that gives rise to the rise of a financial asset for one entity, and a financial liability/equity to the other

All financial instruments are

‘two party items’

• what is an asset to one entity, is a liability to another

A financial asset is any asset that is:

• cash

• an equity instrument of another entity (shares)

• a contractual right

• a contract that will be settled in the entity’s own equity instruments

Financial Assets - Contractual Rights

• to receive cash or other financial assets from another entity

• to exchange financial assets/liabilities with another entity under conditions that ar potentially favourable to the entity

A Financial Liability is

the opposite of a financial asset

Things that are not Financial Instruments

• physical assets

• intangible assets

• prepaid expenses

• deferred revenue

• warranty obligations

• contractual rights

Financial Instruments are

found IFRS 9

Recognition of Financial Instruments

financial instruments are recognised on the SFP when the entity becomes “party to the contractual provisions of the instrument”

Measurement of Financial Instruments

• initial measurement

• subsequent measurement

Initial Measurement of Financial Instruments - Assets

• measured at FV + transaction costs

Subsequent Measurement

• measured at amortised cost

  • amortised using the effective interest method over the period to maturity

Initial Measurement - Financial Liability

• Fair Value - Transaction Cost

Fair Value is

the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (IFRS 13)

Determining Fair Value:

• the principal market for an asset or liability

• the highest and best use of an asset

• assumptions that marker participants would use to price an asset or liability

IFRS 13 Hierarchy of Inputs

1. Quoted prices in active markets for identical assets

2. Inputs other than quoted prices that are directly/indirectly observable

3. Unobservable Inputs

When instruments cannot be reliably calculated,

should be measured at cost

Subsequent Measurement - Amortised Cost

• all financial assets are assumed to be held within a business model whose objective is to hold the assets to collect contractual cash flows being the receipt of interest and capital

• these will be held at amortised cost

Amortised Cost - Financial Assets (Loan Receivable)

B/F Receivable + Effective Interest - Cash Received = C/F Receivable

Amortised Cost - Financial Liability (Loan Payable)

B/F Payable + Effective Interest - Cash Received = C/F Payable

IAS 32

Presentation of Financial Instruments

1. Financial Assets

2. Financial Liabilities

3. Equity Instruments

Equity Instruments are

contracts that evidence a residual interest in the assets of an entity after deducting all of its liabilities

• e.g. a company’s own ordinary shares and irredeemable preference shares

Financial Instruments should

be classified according to the substance of he contract under which it has been issued

• financial asset

• financial liability

• equity instrument

Preference Shares provide the holder with the right:

• to receive an annual dividend out of profits (usually predetermined amount)

• and a fixed amount on ultimate liquidation/an earlier date if the shares are redeemable

The legal form of the instrument (preference shares) is

equity but we account by substance (liabilities)

Preference Shares:

• the fixed level of dividend is treated as a finance cost and expensed to P/L

• the redemption amount is effectively the repayment of the liability

Preference shares will be treated as liabilities when

they are not redeemable but the right to the dividends is mandatory and cumulative

Only Irredeemable Preference Shares with no mandatory requirement to pay dividends

are included in equity

Compound Instruments are

those which show characteristics of equity and financial liabilities

Convertible Debt - on the day of issue, this is separated into:

Liability Component and Equity Component

Convertible Debt - Liability Component

• FV should be measured at the PV of the future expected cash flows

• PV should be discounted at the market rate for a non-convertible instrument

• be held at amortised cost

Convertible Debt - Equity Component

• FV of the equity component is the remainder of the issue proceeds

Financial Liability recognise

related interest, dividends, losses and gains in profit and loss for the period.

The costs of servicing the financing of a company must be

treated consistently with the way that the underlying instrument has been treated

Ordinary Shares/Irredeemable Preference Shares - Cost of Servicing

Dividends - appropriation of profit in the statement of changes in equity

Cost of Issue - deducted from equity net of any income tax benefit

Loans - Cost of Servicing

Finance Cost - in P/L

Preference Shares - Cost of Servicing

Finance Cost - in P/L

Offsetting with Financial Assets and Liabilities

should generally be presented as separate items in the statement of F/P

Offsetting is required if:

• the entity has the legal right to offset

• the entity intends to settle on a net basis

Treasury Shares

It is becoming increasingly popular for companies to reacquire their own shares:

• as an alternative to making dividend distributions

• as a way to return excess capital to shareholders

Treasury Shares are

equity instruments reacquired by the entity which issued them

The treatment of Treasury Shares is that:

• they should be deducted from equity

• no gain/loss should be recognised in the P/L on their purchase/sale/issue

• consideration paid should be recognised directly in equity

Treasury Shares held

should be disclosed in the statement of financial position or in the notes to the financial statements in accordance with IAS 1

Ethical and Judgement Issues

• failure to report financial instruments

• complexity of the financial instrument and the increase in judgement required as a result could raise ethical issues:

  • professional competence

  • objectivity

Assurance Issues with Financial Instruments

• complexity

• judgement around classification

• compound financial instruments

• matching

• expensing the coupon interest and not recognising the EIR

• inappropriate offsetting

• liabilities

Audit of Loans - Procedures

• obtain schedule of loans and inspect associated loan agreements to test loan schedule is complete and presented appropriately

• inspect bank letter to agree loan balances outstanding to it and to confirm valuation

• inspect loan agreements for interest charges and accruals and recalculate to confirm accuracy

• inspect board minutes, bank records, other correspondence for evidence of new loans which may have been omitted

A Covenant is

a condition imposed on a financial instrument, usually by the institution that has advanced any funds involved, that requires the party liable for those funds to fulfil certain conditions