Chapter 16 Financial Assets and Liabilities

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Objectives
Define financial instruments in terms of financial assets and financial liabilities. Distinguish between the categories of financial instruments. Distinguish between debt and equity. Indicate for the categories of financial instruments how they should be measured and how any gains and losses from subsequent measurement should be treated in the financial statements. Account for compound instruments. Account for the issue of redeemable preference shares and payment of preference share di!idends.

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$inancial Assets and $inancial %iabilities

Definitions 1. $inancial assets 2. $inancial liabilities 3. &quity instrument

Recognition 1. Initial 2. Derecognition

Measure ent 1. Initial 2. 'lassification 3. (ubsequent 4. )ains * losses 5. Impairment

!resentation 1. Difference between liability * equity 2. 'ompound financial instruments 3. Interests * di!idends

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Financial #nstru ents

Definitions +a, +b, A financial instru ent is any contract that gi!es rise to a financial asset of one entity and a financial liability or equity instrument of another entity. A financial assets is any asset that is+i, cash +ii, a contractual right to recei!e cash or another financial asset from another entity +iii, a contractual right to e.change financial assets/liabilities with another entity under conditions that are potentially fa!ourable +i!, an equity instrument of another entity. &.amples 0rade recei!ables 1ptions In!estment in equity shares A financial liabilit$ is any liability that is a contractual obligation+i, to deli!er cash or another financial asset to another entity2 or +ii, to e.change financial instruments with another entity under conditions that are potentially unfa!ourable2 or +iii, that will or may be settled in the entity3s own equity instruments. &.amples 0rade payables Debenture loans 4edeemable preference shares An e%uit$ instru ent is any contract that e!idences a residual interest in the assets of an entity after deducting all of its liabilities.

+c,

+d,

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&'a ple 1 Identify which of the following are financial instruments+a, in!entories +b, in!estment in ordinary shares +c, prepayments for goods or ser!ices +d, liability for income ta.es

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+e,

a share option +an entity3s obligation to issue its own shares,

(olution) +a, In!entory +or any other physical asset such as non#current assets, is not a financial instru ent since there is no present contractual right to recei!e cash or other financial instruments. An in!estment in ordinary shares is a financial asset since it is an e%uit$ instru ent of another entit$. 5repayments for goods or ser!ices are not financial instru ents since the future economic benefits will be the receipt of goods or services rather than a financial asset. A liability for income ta.es is not a financial instru ent since the obligation is statutor$ rather than contractual. A share option is a financial instrument since a contractual obligation does e'ist to deliver an e%uit$ instru ent. "ote2 howe!er2 that an option buy or sell an asset other than a financial instrument +e.g. a commodity, would not qualify as a financial instrument.

+b, +c,

+d, +e,

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0here are four reporting standards that deal with financial instruments+a, 67A( 32 $inancial instruments- presentation Deals with the classification of financial instruments and their presentation in financial statements. +b, 67A( 38 $inancial instruments- recognition and measurement Deals with how financial instruments are measured and when they should be recogni9ed in financial statements. +c, 67$4( : $inancial instruments- disclosures Deals with the disclosure of financial instruments in financial statements. +d, 67$4( 8 $inancial instruments Issued on "o!ember 2;;8 and re!ised on December 2;1;. It will e!entually replace 67A( 38 and effecti!e for accounting periods commencing from 1 <anuary 2;13.

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Recognition of Financial #nstru ents

#nitial Recognition An entity should recogni9e a financial asset or a financial liability in its statement of financial position+a, when2 and only when2 it beco es a part$ to the contractual provisions of the instrument +b, at fair value of consideration given+received2 i.e. this is normally cost.

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Derecognition $inancial instruments should be derecogni9ed as follows+a, Financial asset = when2 and only when2 the contractual rights to the cash flows of the financial asset ha!e e'pired2 e.g. when an option held b$ the entit$ has e'pired and beco e ,orthless or when the financial asset has been sold and the transfer qualifies for derecognition because substantiall$ all the ris-s and re,ards of o,nership ha!e been transferred from the seller to the buyer. +b, Financial liabilit$ = when2 and only when2 the obligation specified in the contract is discharged. cancelled or e'pired. 1n derecognition = the difference bet,een the carr$ing a ount of the asset or liability2 and the a ount received or paid for it 2 should be included in the profit or loss for the period.

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Measure ent of Financial #nstru ents

#nitial easure ent

#nitial Measure ent $inancial instruments are initiall$ easured at the fair value of the consideration gi!en or recei!ed +i.e. cost, plus +in most cases, transaction costs that are directly attributable to the acquisition or issue of the financial instrument. 0he e'ception to this rule is where a financial instrument is designated as at fair value through profit or loss. In this case2 transaction costs are not added to fair
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value at initial recognition. 0he fair value of the consideration is nor all$ the transaction price or ar-et prices. If mar>et prices are not reliable2 the fair !alue may be esti ated using a valuation techni%ue +for e.ample2 by discounting cash flows,.

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Definitions +a, A financial asset or liability at fair value through profit or loss meets either of the following conditions+i, It is classified as held for trading. A financial instrument is classified as held for trading if it is+1, acquired or incurred principally for the purpose of selling or repurchasing it in the near ter ? +2, part of a portfolio of identified financial instruments that are measured together and for which there is e!idence of a recent actual pattern of short2ter profit2ta-ing. +ii, @pon initial recognition it is designated b$ the entit$ as at fair value through profit or loss. 3eld2to2 aturit$ invest ents are non#deri!ati!e financial assets with fi'ed or deter inable pa$ ents and fi'ed aturit$ that an entity has the positi!e intent and ability to hold to maturity. %oan and recei!ables are non#deri!ati!e financial assets with fi.ed or determinable payments that are not quoted in an acti!e mar>et. Available2for2sale financial assets are those financial assets that are not+i, loans and recei!ables originated by the entity2 +ii, held#to#maturity in!estments2 or +iii, financial assets at fair !alue through profit or loss. easure ent

+b,

+c, +d,

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(ubse%uent

(ubse%uent Measure ent After initial recognition2 all financial assets should be re easured to fair value2 without any deduction for transaction costs that may be incurred on sale or other disposal2 e'cept for+a, %oan and recei!ables

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+b, +c,

6eld to maturity in!estments In!estments in equity instruments that do not ha!e a quoted mar>et price in an acti!e mar>et and whose fair !alue cannot be reliably measured. easured at

Loans and receivables and held to aturit$ invest ents should be a ortised cost using the effective interest ethod. 4.4 &'a ple " 5 A ortised cost

1n 1 <anuary 2;11 AA' 'o purchases a debt instrument for its fair !alue of B12;;;. 0he debt instrument is due to mature on 31 December 2;15. 0he instrument has a principal amount of B1225; and the instrument carries fi.ed interest at 4.:2C that is paid annually. 0he effecti!e rate of interest is 1;C. 6ow should AA' 'o account for the debt instrument o!er its fi!e year termD (olution) AA' 'o will recei!e interest of B58 +1225; E 4.:2C, each year and B1225; when the instrument matures. AA' 'o must allocate the discount of B25; and the interest recei!able o!er the fi!e year term at a constant rate on the carrying amount of the debt. 0o do this2 it must apply the effecti!e interest rate of 1;C. 0he following table shows the allocation o!er the yearsFear Amortised cost at beginning of year B 12;;; 12;41 12;H 1213 1218; Income statementinterest income for year +G1;C, B 1;; 1;4 1;8 113 118 Interest recei!ed during year +cash inflow, B +58, +58, +58, +58, +1225; I 58, Amortised cost at end of year B 12;41 12;H 1213 1218; #

2;11 2;12 2;13 2;14 2;15

&ach year the carrying amount of the financial asset is increased by the interest
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income for the year and reduced by the interest actually recei!ed during the year. In!estments whose fair !alue cannot be reliably measured should be measured at cost. 0C1 4.5 4. 6ains and losses Instruments at fair value through profit or loss - gains and losses are recognised in profit or loss +ie2 in the income statement,. Available for sale financial assets- gains and losses are recognised directl$ in e%uit$ through the state ent of co prehensive inco e. Jhen the asset is derecognised the cu ulative gain or loss previousl$ recognised in e%uit$ should be recognised in profit or loss. $inancial instruments carried at a ortised cost- gains and losses are recognised in profit and loss as a result of the amortisation process and when the asset is derecognised. # pair ent and uncollectabilit$ of financial assets At each balance sheet date2 an entity should assess whether there is any obKecti!e e!idence that a financial asset or group of assets is impaired. Jhere there is obKecti!e e!idence of impairment2 the entity should determine the amount of any impairment loss.

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!resentation of Financial #nstru ents

67A( 32 requires the classification of a financial instrument2 or its component parts2 as a liability or as equity according to the substance of the contractual arrangement. Liabilities and e%uit$ 0he main thrust of IA( 32 is that financial instruments should be presented according to their substance2 not erel$ their legal for . In particular2 entities which issue financial instruments should classify them +or their component parts, as either financial liabilities2 or equity. 6ow should a financial liabilit$ be distinguished fro an e%uit$ instru ent D 0he critical feature of a liabilit$ is an obligation to transfer economic benefit. 0herefore a

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financial instrument is a financial liability if there is a contractual obligation on the issuer either to deli!er cash or another financial asset to the holder or to e.change another financial instrument with the holder under potentially unfa!ourable conditions to the issuer. Jhere the abo!e critical feature is not met2 then the financial instrument is an e%uit$ instru ent. 67A( 32 e.plains that although the holder of an equity instrument may be entitled to a pro rata share of any distributions out of equity2 the issuer does not have a contractual obligation to a-e such a distribution. Lany entities issue preference shares which must be redee ed b$ the issuer for a fi'ed 0or deter inable1 a ount at a fi'ed 0or deter inable1 future date . Alternati!ely2 the holder may ha!e the right to require the issuer to redeem the shares at or after a certain date for a fi.ed amount. In such cases2 the issuer has an obligation. 0herefore the instrument is a financial liabilit$ and should be classified as such. 0he distinction between redee able and non2redee able preference shares is important. Lost preference shares are redee able and are therefore classified as a financial liabilit$. Co pound financial instru ents (ome financial instruments contain both a liabilit$ and an e%uit$ ele ent . In such cases2 67A( 32 requires the component parts of the instrument to be classified separatel$2 according to the substance of the contractual arrangement and the definitions of a financial liability and an equity instrument. 1ne of the most common types of compound instrument is convertible debt. 0his creates a primary financial liability of the issuer and grants an option to the holder of the instrument to con!ert it into an equity instrument +usually ordinary shares, of the issuer. 0his is the economic equi!alent of the issue of con!entional debt plus a warrant to acquire shares in the future. 0he two elements must be separately recogni9ed in the statement of financial position+a, the liability element +b, the equity element. 0o account for a con!ertible debt +loan,+a, Calculate fair value of liabilit$ component first +i, based on present value of future cash flo,s assuming non# con!ersion2 +ii, appl$ discount rate e%uivalent to interest on si ilar non2 convertible debt instru ent. +b, &%uit$ 8 re ainder
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&'a ple * 5 Co pound instru ents AA' 'o issues a con!ertible loan that attracts interest of 2C. 0he mar>et rate is HC2 being the interest rate for an equi!alent debt without the con!ersion option. 0he loan of B5 million is repayable in full after three years or con!ertible to equity. Discount factors are as followsFear 1 2 3 Re%uired) (plit the loan between debt and equity at inception and calculate the finance charge for each year until con!ersion/redemption. (olution) At inceptionFear 1 2 3 Debt &quity +bal., 'ash inflow 9ear 1 2 3 Opening B;;; 4222: 424 5 42:22 Finance 0:;1 B;;; 33H 35: 3:H !aid B;;; +1;;, +1;;, +1;;, Discount factor at HC ;.82 ;.H5: ;.:84

'ash flow +B;;;, 1;; 1;; 521;;

D$ G HC ;.823 ;.H5: ;.:84

5M +B;;;, 82 H 42;48 4222: ::3 52;;; Closing B;;; 424 5 42:22 52;;;

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#nterest and dividends As well as loo>ing at presentation in the statement of financial position2 67A( 32 considers how financial instruments affect the income statement or statement of comprehensi!e income +and mo!ements in equity,. 0he treatment !aries according to whether interest2 di!idends2 losses or gains relate to a financial liability or an equity instrument. +a, &%uit$ dividends declared are reported directly in e%uit$. +b, Dividends on redee able preference shares classified as a liabilit$ are an e'pense in the income statement. &'a ple / 5 Redee able preference shares 1n 1 April 2;1;2 a company issued 4;2;;; B1 redeemable preference shares with a coupon rate of HC at par. 0hey are redeemable at a large premium which gi!es them an effecti!e finance cost of 12C per annum. 6ow would these redeemable preference shares appear in the financial statements for the years ending 31 Larch 2;11 and 2;12D (olution) Annual payment N B4;2;;; . HC N B322;; 9ear 2;11 2;12 Opening B 4;2;;; 412 ;; Finance 01";1 B 42H;; 42882 !aid < :; B +322;;, +322;;, Closing B 412 ;; 432382

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9ear ended *1 March "=11 #nco e state ent 0e'tract1 = $inance cost (tate ent of financial position 0e'tract1 "on#current liabilities = 4edeemable preference shares 9ear ended *1 March "=1"

B42H;;

B412 ;;

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#nco e state ent 0e'tract1 = $inance cost (tate ent of financial position 0e'tract1 "on#current liabilities = 4edeemable preference shares

B42882

B432382

&'a ination (t$le >uestions >uestion 1 1n 1 April 2;;5 5eterlee issued an HC B5 million con!ertible loan at par. 0he loan is con!ertible in three years time to ordinary shares or redeemable at par in cash. 0he directors decided to issue a con!ertible loan because a non#con!ertible loan would ha!e required an interest rate of 1;C. 0he directors intend to show the loan at B5 million under non#current liabilities. 0he following discount rates are a!ailableHC ;.83 ;.H ;.:8 1;C ;.81 ;.H3 ;.:5

Fear 1 Fear 2 Fear 3 Re%uired)

Describe +and quantify where possible, how 5eterlee should treat the abo!e item in its financial statements for the year ended 31 Larch 2;; commenting on the directors3 !iews where appropriate. +4 mar>s, +A''A 2.5 $inancial 4eporting <une 2;; O3c+iii,, >uestion " 1n 1 <anuary 2;1;2 <edders issued B15m of :C con!ertible loan notes at par. 0he loan notes are con!ertible into equity shares in the company2 at the option of the note holders2 fi!e years after the date of issue +31 December 2;14, on the basis of 25 shares for each B1;; of loan stoc>. Alternati!ely2 the loan notes will be redeemed at par. <edders has been ad!ised by $ab $actors that2 had the company issued similar loan notes without the con!ersion rights2 then it would ha!e had to pay interest of 1;C? the rate is thus lower because the con!ersion rights are fa!ourable.

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$ab $actors also suggest that2 as some of the loan note holders will choose to con!ert2 the loan notes are2 in substance2 equity and should be treated as such on <eddersP statement of financial position. 0hus2 as well as a reduced finance cost being achie!ed to boost profitability2 <eddersP gearing has been impro!ed compared to a straight issue of debt. 0he present !alue of B1 recei!able at the end of each year2 based on discount rates of :C and 1;C can be ta>en as:C ;.83 ;.H: ;.H2 ;.: ;.:1 1;C ;.81 ;.H3 ;.:5 ;. H ;. 2

Fear 1 Fear 2 Fear 3 Fear 4 Fear 5 Re%uired)

In relation to the :C con!ertible loan notes2 calculate the finance cost to be shown in the income statement and the statement of financial position e.tracts for the year to 31 December 2;Q; for <edders and comment on the ad!ice from $ab $actors. +5 mar>s, >uestion * 5ingway issued a B1; million 3C con!ertible loan note at par on 1 April 2;;: with interest payable annually in arrears. 0hree years later2 on 31 Larch 2;1;2 the loan note is con!ertible into equity shares on the basis of B1;; of loan note for 25 equity shares or it may be redeemed at par in cash at the option of the loan note holder. 1ne of the company3s financial assistants obser!ed that the use of a con!ertible loan note was preferable to a non#con!ertible loan note as the latter would ha!e required an interest rate of HC in order to ma>e it attracti!e to in!estors. 0he assistant has also commented that the use of a con!ertible loan note will impro!e the profit as a result of lower interest costs and2 as it is li>ely that the loan note holders will choose the equity option2 the loan note can be classified as equity which will impro!e the company3s high gearing position. 0he present !alue of B1 recei!able at the end of the year2 based on discount rates of 3C and HC can be ta>en as-

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Fear 1 Fear 2 Fear 3 Re%uired)

3C ;.8: ;.84 ;.82

HC ;.83 ;.H ;.:8

'omment on the financial assistant3s obser!ations and show how the con!ertible loan note should be accounted for in 5ingway3s income statement for the year ended 31 Larch 2;;H and statement of financial position as at that date. +1; mar>s, +A''A $: $inancial 4eporting <une 2;;H O5,

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