Chapter 16 Financial Assets and Liabilities

1.       Objectives

1.1       Define financial instruments in terms of financial assets and financial liabilities.
1.2       Distinguish between the categories of financial instruments.
1.3       Distinguish between debt and equity.
1.4       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.
1.5       Account for compound instruments.
1.6       Account for the issue of redeemable preference shares and payment of preference share dividends.

 

2.       Financial Instruments

2.1

Definitions

(a)        A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. (b)        A financial assets is any asset that is: (i)         cash (ii)        a contractual right to receive cash or another financial asset from another entity (iii)       a contractual right to exchange financial assets/liabilities with another entity under conditions that are potentially favourable (iv)       an equity instrument of another entity. Examples: Trade receivables Options Investment in equity shares (c)        A financial liability is any liability that is a contractual obligation: (i)         to deliver cash or another financial asset to another entity, or (ii)        to exchange financial instruments with another entity under conditions that are potentially unfavourable, or (iii)       that will or may be settled in the entity’s own equity instruments. Examples: Trade payables Debenture loans Redeemable preference shares (d)        An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

2.2

Example 1

Identify which of the following are financial instruments: (a)        inventories (b)        investment in ordinary shares (c)        prepayments for goods or services (d)        liability for income taxes (e)        a share option (an entity’s obligation to issue its own shares) Solution: (a)        Inventory (or any other physical asset such as non-current assets) is not a financial instrument since there is no present contractual right to receive cash or other financial instruments. (b)        An investment in ordinary shares is a financial asset since it is an equity instrument of another entity. (c)        Prepayments for goods or services are not financial instruments since the future economic benefits will be the receipt of goods or services rather than a financial asset. (d)        A liability for income taxes is not a financial instrument since the obligation is statutory rather than contractual. (e)        A share option is a financial instrument since a contractual obligation does exist to deliver an equity instrument. Note, however, that an option buy or sell an asset other than a financial instrument (e.g. a commodity) would not qualify as a financial instrument.

2.3       There are four reporting standards that deal with financial instruments:
(a)        HKAS 32 Financial instruments: presentation
Deals with the classification of financial instruments and their presentation in financial statements.
(b)        HKAS 39 Financial instruments: recognition and measurement
Deals with how financial instruments are measured and when they should be recognized in financial statements.
(c)        HKFRS 7 Financial instruments: disclosures
Deals with the disclosure of financial instruments in financial statements.
(d)        HKFRS 9 Financial instruments
Issued on November 2009 and revised on December 2010. It will eventually replace HKAS 39 and effective for accounting periods commencing from 1 January 2013.

 

3.       Recognition of Financial Instruments

3.1	Initial Recognition
	An entity should recognize a financial asset or a financial liability in its statement of financial position: (a)        when, and only when, it becomes a party to the contractual provisions of the instrument (b)        at fair value of consideration given/received, i.e. this is normally cost.

3.2

Derecognition

Financial instruments should be derecognized as follows: (a)        Financial asset – when, and only when, the contractual rights to the cash flows of the financial asset have expired, e.g. when an option held by the entity has expired and become worthless or when the financial asset has been sold and the transfer qualifies for derecognition because substantially all the risks and rewards of ownership have been transferred from the seller to the buyer. (b)        Financial liability – when, and only when, the obligation specified in the contract is discharged, cancelled or expired. On derecognition – the difference between the carrying amount of the asset or liability, and the amount received or paid for it, should be included in the profit or loss for the period.

4.       Measurement of Financial Instruments

(A)       Initial measurement

4.1

Initial Measurement

Financial instruments are initially measured at the fair value of the consideration given or received (i.e. cost) plus (in most cases) transaction costs that are directly attributable to the acquisition or issue of the financial instrument. The exception to this rule is where a financial instrument is designated as at fair value through profit or loss. In this case, transaction costs are not added to fair value at initial recognition. The fair value of the consideration is normally the transaction price or market prices. If market prices are not reliable, the fair value may be estimated using a valuation technique (for example, by discounting cash flows).

4.2

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 term; (2)        part of a portfolio of identified financial instruments that are measured together and for which there is evidence of a recent actual pattern of short-term profit-taking. (ii)        Upon initial recognition it is designated by the entity as at fair value through profit or loss. (b)        Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intent and ability to hold to maturity. (c)        Loan and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. (d)        Available-for-sale financial assets are those financial assets that are not: (i)         loans and receivables originated by the entity, (ii)        held-to-maturity investments, or (iii)       financial assets at fair value through profit or loss.

(B)       Subsequent measurement

4.3

Subsequent Measurement

After initial recognition, all financial assets should be remeasured to fair value, without any deduction for transaction costs that may be incurred on sale or other disposal, except for: (a)       Loan and receivables (b)       Held to maturity investments (c)       Investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured. Loans and receivables and held to maturity investments should be measured at amortised cost using the effective interest method.

4.4

Example 2 – Amortised cost

On 1 January 2011 ABC Co purchases a debt instrument for its fair value of $1,000. The debt instrument is due to mature on 31 December 2015. The instrument has a principal amount of $1,250 and the instrument carries fixed interest at 4.72% that is paid annually. The effective rate of interest is 10%. How should ABC Co account for the debt instrument over its five year term? Solution: ABC Co will receive interest of $59 (1,250 × 4.72%) each year and $1,250 when the instrument matures. ABC Co must allocate the discount of $250 and the interest receivable over the five year term at a constant rate on the carrying amount of the debt. To do this, it must apply the effective interest rate of 10%. The following table shows the allocation over the years: Year Amortised cost at beginning of year Income statement: interest income for year (@10%) Interest received during year (cash inflow) Amortised cost at end of year   $ $ $ $ 2011 1,000 100 (59) 1,041 2012 1,041 104 (59) 1,086 2013 1,086 109 (59) 1,136 2014 1,136 113 (59) 1,190 2015 1,190 119 (1,250 + 59) - Each year the carrying amount of the financial asset is increased by the interest income for the year and reduced by the interest actually received during the year. Investments whose fair value cannot be reliably measured should be measured at cost.

(C)      Gains and losses

4.5       Instruments at fair value through profit or loss: gains and losses are recognised in profit or loss (ie, in the income statement).
4.6       Available for sale financial assets: gains and losses are recognised directly in equity through the statement of comprehensive income. When the asset is derecognised the cumulative gain or loss previously recognised in equity should be recognised in profit or loss.
4.7       Financial instruments carried at amortised cost: gains and losses are recognised in profit and loss as a result of the amortisation process and when the asset is derecognised.

(D)      Impairment and uncollectability of financial assets

4.8       At each balance sheet date, an entity should assess whether there is any objective evidence that a financial asset or group of assets is impaired.
4.9       Where there is objective evidence of impairment, the entity should determine the amount of any impairment loss.

5.      Presentation of Financial Instruments

5.1       HKAS 32 requires the classification of a financial instrument, or its component parts, as a liability or as equity according to the substance of the contractual arrangement.

(A)       Liabilities and equity

5.2      The main thrust of IAS 32 is that financial instruments should be presented according to their substance, not merely their legal form. In particular, entities which issue financial instruments should classify them (or their component parts) as either financial liabilities, or equity.
5.3       How should a financial liability be distinguished from an equity instrument? The critical feature of a liability is an obligation to transfer economic benefit. Therefore a financial instrument is a financial liability if there is a contractual obligation on the issuer either to deliver cash or another financial asset to the holder or to exchange another financial instrument with the holder under potentially unfavourable conditions to the issuer.
5.4       Where the above critical feature is not met, then the financial instrument is an equity instrument. HKAS 32 explains that although the holder of an equity instrument may be entitled to a pro rata share of any distributions out of equity, the issuer does not have a contractual obligation to make such a distribution.
5.5       Many entities issue preference shares which must be redeemed by the issuer for a fixed (or determinable) amount at a fixed (or determinable) future date. Alternatively, the holder may have the right to require the issuer to redeem the shares at or after a certain date for a fixed amount. In such cases, the issuer has an obligation. Therefore the instrument is a financial liability and should be classified as such.
5.6       The distinction between redeemable and non-redeemable preference shares is important. Most preference shares are redeemable and are therefore classified as a financial liability.

(B)       Compound financial instruments

5.7       Some financial instruments contain both a liability and an equity element. In such cases, HKAS 32 requires the component parts of the instrument to be classified separately, according to the substance of the contractual arrangement and the definitions of a financial liability and an equity instrument.
5.8       One of the most common types of compound instrument is convertible debt. This creates a primary financial liability of the issuer and grants an option to the holder of the instrument to convert it into an equity instrument (usually ordinary shares) of the issuer. This is the economic equivalent of the issue of conventional debt plus a warrant to acquire shares in the future.
5.9       The two elements must be separately recognized in the statement of financial position:
(a)        the liability element
(b)       the equity element.
5.10     To account for a convertible debt (loan):
(a)        Calculate fair value of liability component first
(i)        based on present value of future cash flows assuming non-conversion,
(ii)       apply discount rate equivalent to interest on similar non-convertible debt instrument.
(b)       Equity = remainder

 

5.11

Example 3 – Compound instruments

ABC Co issues a convertible loan that attracts interest of 2%. The market rate is 8%, being the interest rate for an equivalent debt without the conversion option. The loan of $5 million is repayable in full after three years or convertible to equity. Discount factors are as follows: Year Discount factor at 8% 1 0.926 2 0.857 3 0.794 Required: Split the loan between debt and equity at inception and calculate the finance charge for each year until conversion/redemption. Solution: At inception: Year Cash flow ($000) DF @ 8% PV ($000) 1 100 0.923 92 2 100 0.857 86 3 5,100 0.794 4,049 Debt     4,227 Equity (bal.)     773 Cash inflow     5,000 Year Opening Finance (8%) Paid Closing   $000 $000 $000 $000 1 4,227 338 (100) 4,465 2 4,465 357 (100) 4,722 3 4,722 378 (100) 5,000

 

(C)       Interest and dividends

5.12     As well as looking at presentation in the statement of financial position, HKAS 32 considers how financial instruments affect the income statement or statement of comprehensive income (and movements in equity). The treatment varies according to whether interest, dividends, losses or gains relate to a financial liability or an equity instrument.
(a)        Equity dividends declared are reported directly in equity.
(b)       Dividends on redeemable preference shares classified as a liability are an expense in the income statement.

5.13

Example 4 – Redeemable preference shares

On 1 April 2010, a company issued 40,000 $1 redeemable preference shares with a coupon rate of 8% at par. They are redeemable at a large premium which gives them an effective finance cost of 12% per annum. How would these redeemable preference shares appear in the financial statements for the years ending 31 March 2011 and 2012? Solution: Annual payment = $40,000 x 8% = $3,200 Year Opening Finance (12%) Paid @ 8% Closing   $ $ $ $ 2011 40,000 4,800 (3,200) 41,600 2012 41,600 4,992 (3,200) 43,392 Year ended 31 March 2011 Income statement (extract) – Finance cost                                                    $4,800 Statement of financial position (extract) Non-current liabilities                                         – Redeemable preference shares                        $41,600 Year ended 31 March 2012 Income statement (extract) – Finance cost                                                    $4,992 Statement of financial position (extract) Non-current liabilities                                         – Redeemable preference shares                        $43,392

Examination Style Questions

Question 1
On 1 April 2005 Peterlee issued an 8% $5 million convertible loan at par. The loan is convertible in three years time to ordinary shares or redeemable at par in cash. The directors decided to issue a convertible loan because a non-convertible loan would have required an interest rate of 10%. The directors intend to show the loan at $5 million under non-current liabilities. The following discount rates are available:

	8%	10%
Year 1	0.93	0.91
Year 2	0.86	0.83
Year 3	0.79	0.75

Required:

Describe (and quantify where possible) how Peterlee should treat the above item in its financial statements for the year ended 31 March 2006 commenting on the directors’ views where appropriate. (4 marks)
(ACCA 2.5 Financial Reporting June 2006 Q3c(iii))

Question 2
On 1 January 2010, Jedders issued $15m of 7% convertible loan notes at par. The loan notes are convertible into equity shares in the company, at the option of the note holders, five years after the date of issue (31 December 2014) on the basis of 25 shares for each $100 of loan stock. Alternatively, the loan notes will be redeemed at par.

Jedders has been advised by Fab Factors that, had the company issued similar loan notes without the conversion rights, then it would have had to pay interest of 10%; the rate is thus lower because the conversion rights are favourable.

Fab Factors also suggest that, as some of the loan note holders will choose to convert, the loan notes are, in substance, equity and should be treated as such on Jedders' statement of financial position. Thus, as well as a reduced finance cost being achieved to boost profitability, Jedders' gearing has been improved compared to a straight issue of debt.

The present value of $1 receivable at the end of each year, based on discount rates of 7% and 10% can be
taken as:

	7%	10%
Year 1	0.93	0.91
Year 2	0.87	0.83
Year 3	0.82	0.75
Year 4	0.76	0.68
Year 5	0.71	0.62

Required:

In relation to the 7% convertible loan notes, calculate the finance cost to be shown in the income statement and the statement of financial position extracts for the year to 31 December 20X0 for Jedders and comment on the advice from Fab Factors.                                                                                                (5 marks)

Question 3
Pingway issued a $10 million 3% convertible loan note at par on 1 April 2007 with interest payable annually in arrears. Three years later, on 31 March 2010, the loan note is convertible into equity shares on the basis of $100 of loan note for 25 equity shares or it may be redeemed at par in cash at the option of the loan note holder. One of the company’s financial assistants observed that the use of a convertible loan note was preferable to a non-convertible loan note as the latter would have required an interest rate of 8% in order to make it attractive to investors. The assistant has also commented that the use of a convertible loan note will improve the profit as a result of lower interest costs and, as it is likely that the loan note holders will choose the equity option, the loan note can be classified as equity which will improve the company’s high gearing position.

The present value of $1 receivable at the end of the year, based on discount rates of 3% and 8% can be taken as:

	3%	8%
Year 1	0.97	0.93
Year 2	0.94	0.86
Year 3	0.92	0.79

Required:

Comment on the financial assistant’s observations and show how the convertible loan note should be accounted for in Pingway’s income statement for the year ended 31 March 2008 and statement of financial position as at that date.                                                                                                                        (10 marks)
(ACCA F7 Financial Reporting June 2008 Q5)