FINANCIAL INSTRUMENTS

Transcription

1 page 48 student accountant NOVEMBER/DECEMBER 2008 FINANCIAL INSTRUMENTS understanding the basics RELEVANT TO ACCA QUALIFICATION PAPERS F7 AND P2 This article aims to help students better understand accounting standards relating to financial instruments. It deals with the facts and terminology that you will need to know, understand, and be able to apply when accounting for financial instruments. Also included are exercises that will test your understanding. In order to understand accounting for financial instruments, there is some terminology, together with some principles and rules, that you must understand. Let us start by asking some key questions, looking first at the technically correct answer then trying to put it into more everyday language. KEY QUESTION What are The technically A discussion to financial instruments? correct answer help understanding A financial instrument is As you can see from a contract that gives rise the technical definition, to a financial asset of a financial instrument one entity and a financial is a contract, so it liability or equity may be helpful to think instrument of another of a financial instrument entity. A financial asset as a piece of paper as is any asset that is: cash, contracts are normally an equity instrument of written down. We can another entity, or a also see that this piece contractual right to of paper has two effects receive cash or another in two different financial asset from companies. So if we another entity, or to think of an invoice that exchange financial assets my company issues or financial liabilities with following the sale of another entity under goods, then I have a conditions that are receivable (a financial potentially favourable to asset) but the company the entity; or a contract that has bought the that will or may be goods will consider the settled in the entity s same contract/piece own equity instruments of paper/invoice as a and is: financial liability. In a a non-derivative for similar way, if my which the entity is or company is a lender may be obliged to (ie operates like a bank) receive a variable then I have a financial number of the asset the loan but entity s own equity the borrower has a instruments liability to repay the loan. What are a derivative that will Such written loan financial instruments? or may be settled agreements are often other than by the called debentures. A exchange of a fixed third example is when a amount of cash or company issues another financial ordinary shares (more asset for a fixed pieces of paper). If I number of the subscribe to those entity s own equity shares then in my instruments. For this accounts I have a purpose, the entity s financial asset of the own equity investment in the instruments do not shares, but the issuing include instruments company has created an that are themselves equity instrument. contracts for the Thus we should future receipt or consider examples of delivery of the financial instruments entity s own to be: receivables and equity instruments. payables, investments in debentures and loans, A financial liability is any and investments in liability that is a equity and contractual obligation: ordinary shares. to deliver cash or another financial Of course there are asset to another more complex financial entity, or instruments such as to exchange financial options, swaps and assets or financial futures, collectively liabilities with known as derivatives. another entity under These are held either for conditions that speculation (taking a are potentially risk) or for hedging (to unfavourable to the offset an existing risk). entity, or However, hedge a contract that will accounting does not or may be settled in come under the the entity s own heading of equity instruments. basic information.

2 page 49 LINKED PERFORMANCE OBJECTIVES studying paper F7 OR P2? did you know that PERFORMANCE OBJECTIVES 10 AND 11 ARE linked? When should financial A company should Recognition is the assets and liabilities recognise a financial process of including an be recognised? asset or a financial asset or liability on the liability on its accounts statement of financial when the company position (balance sheet). becomes a party to the To recognise a financial contractual provisions of asset or liability when the instrument, rather you become a party to than when the contract the contract simply is settled. means that when you purchase the shares you show the asset in your accounts, and when you have borrowed the money from the bank you recognise the liability. How are Initially, financial assets All financial assets and financial assets and liabilities should be liabilities should be and liabilities measured at fair value measured at the fair initially measured? (including transaction value of the costs for assets and consideration received liabilities not measured or paid when we enter at fair value through into the contract. In profit or loss). simple terms, this means that if we have purchased an investment for $500 cash, then the asset will be recorded as $500. Transaction costs are generally capitalised just as legal fees would be if we were buying a property. When should financial A company should The derecognition of an assets be derecognised? derecognise a financial asset means that it will asset when either of the no longer be included on following has occurred: the statement of The asset has been financial position sold so that the risks (balance sheet). This and rewards of will normally arise when ownership have the asset is sold. passed away. However, the terminology The contractual of a sale is legal rights to the cash language and what is flow of the financial more important to asset have expired accountants, who have (see Example 5). to show a true and fair view, is the substance of the transaction. Thus we should remember that derecognition involves the passage of the risks and rewards of ownership. When should A financial liability Normally, liabilities financial liabilities should be removed from disappear when they be derecognised? the statement of financial are paid off in the form position (balance sheet) of cash, thus they will when, and only when, it no longer be a claim. is extinguished, that is, Liabilities can also be when the obligation settled by winning a specified in the contract court case or by the is either discharged, issue of shares, eg with cancelled, or expired. convertible loan stock. If there has been an If a creditor is settled for exchange between less than the carrying an existing borrower and value then we have lender of debt a profit instruments with substantially different terms, or there has been a substantial modification of the terms of an existing financial liability, this transaction is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. A gain or loss from extinguishment of the original financial liability is recognised in the income statement. HOW ARE FINANCIAL ASSETS CLASSIFIED AND ACCOUNTED FOR? There are four separate categories of financial assets: Held to maturity investments Available for sale Loans and receivables Fair value through profit or loss. The mnemonic HALF should help you remember this list. Table 1 sets out the relevant information which has to be rote learnt.

3 page 50 student accountant NOVEMBER/DECEMBER 2008 TABLE 1: CATEGORIES OF FINANCIAL ASSETS Category Accounting treatment Additional technical points Example Held-to-maturity investments Held-to-maturity investments If an entity sells a held-to-maturity An example of a held-to-maturity are measured at amortised cost. investment other than in insignificant investment is where a company holds These are financial assets with fixed amounts, or as a consequence of a (as an investment) fixed interest or or determinable payments that an See later in this article for an non-recurring, isolated event beyond fixed-term debt/bonds for the whole entity intends (and is able) to hold explanation as to what accounting its control that could not be of its life. to maturity. at amortised cost means. reasonably anticipated, all of its other held-to-maturity investments must be reclassified as available-for-sale for the current and next two financial reporting years. Available-for-sale financial assets Available-for-sale financial assets The cumulative gain or loss that was An example of an available-for-sale are measured at fair value in the recognised in equity is recognised in asset is a long-term investment in This is a default category. statement of financial position income when an available-for-sale equity shares. (balance sheet). financial asset is derecognised, ie it is The name available-for-sale is quite recycled (see Example 2). Any financial asset that cannot be strange as the majority of financial The changes in value are classified into another category is assets categorised here are going to recognised in reserves (other deemed to fall into the be long-term assets. comprehensive income/statement available-for-sale category, ie it is the of recognised gains and losses). default category. Loans and receivables Loans and receivables are Technically, provisions are no longer An example of loans and receivables measured at amortised cost. made for bad and doubtful debts; is simple trade debtors. These are financial assets with fixed instead, receivables are subject to an or determinable payments, originated impairment review and written down or acquired, that are not quoted in to their recoverable amount. an active market, and not held for trading. Financial assets at fair value through Financial assets at fair value through Allowing the company the choice to An example is a derivative that is profit or loss profit or loss are measured at fair designate any financial asset at fair held for speculation purposes. value in the statement of financial value through profit or loss has the These are all derivatives (except those position (balance sheet). effect of reducing comparability For example, this will occur if a designated as hedging instruments) between companies. company with no foreign currency and financial assets acquired or held The changes in value are recognised assets, liabilities or transactions for the purpose of selling in the short in income. enters into a forward foreign currency term, or for which there is a recent contract (a derivative) with a view to pattern of short-term profit taking, are While derivatives are a potentially making a profit on the contract due to held for trading. complex area, remember that there future changes in exchange rates are only two reasons why a company In addition, any financial asset can be would hold them hedging Such derivative contracts can be designated on initial recognition as or speculation. Of course, changes entered into at no cost or at an one to be measured at fair value with in value of financial assets at fair immaterial cost so it is important to fair value changes in profit or loss. value through profit or loss should be have it recognised at fair value at the This is the so-called fair value option. recognised in income, as not only is year end otherwise it would that what their name implies but also be invisible. because they arise from speculation or trading activities.

4 page 51 HOW ARE FINANCIAL LIABILITIES CLASSIFIED AND ACCOUNTED FOR? Technically, there are two categories of financial liabilities, detailed in Table 2, although the vast majority in reality, and in the exam, will be measured at amortised cost. TABLE 2: CATEGORIES OF FINANCIAL LIABILITY Category Accounting treatment Example Financial liabilities measured at amortised cost Examples include trade This is the These are measured at creditors, loans, and default category. amortised cost. debenture liabilities. Financial liabilities at Financial liabilities at fair value through profit fair value through or loss profit or loss are measured at fair value Like financial assets, in the statement of these are speculative financial position derivatives, and those (balance sheet). The An example is a liabilities that have been changes in value are derivative that is held so designated. recognised in income. for speculation purposes. WHAT EXACTLY IS MEANT BY THE ACCOUNTING TREATMENT AMORTISED COST? Technically, accounting for an asset or liability using amortised cost means that the income statement will reflect the effective rate of interest of the financial asset or liability. The effective rate of interest is the true interest rate reflecting the market rate. It is always given in accounting exams though using financial management techniques can sometimes be calculated as the IRR. The effective rate of interest may or may not be the same as the amount of the annual cash flow associated with the instrument. Let s take a step back and remember that if we account for land at cost then this means that the carrying value will not change year on year as the historic cost never changes. If we account for plant then, as it has a limited life, we can account for it using depreciated cost. This would mean that although the asset is never revalued, the carrying value would reduce each year to reflect the depreciation being charged. If we account for a liability using amortised cost then, again, it has not been revalued but it will go up each year by the effective rate of interest, charged as an expense (DR Income Interest payable CR Liability), and reduced by the cash actually paid over (DR Liability CR Cash). If more cash is paid than interest charged the net effect is that at the year end the liability will have been reduced over the period. This is what happens with finance lease obligations. EXAMPLE 1 Accounting for a liability using amortised cost If a company borrows $400 over two years and the effective rate of interest is 10% then there has to be a finance charge to income of $40 in the first year. Let us assume that the lender has agreed to be paid interest in arrears at the rate of 5%, which means that the annual cash flow will be (5% x 400) = 20. Under the terms of the loan there will be a premium on redemption of $42. At the end of the first year, the liability will have grown to $420, and, of course, after two years, the liability will be extinguished by the final payment (see Example 3). The following working is a summary of the accounting treatment using amortised cost: Opening Income statement Cash flow Year end effective interest rate balance of 10% Year (20) 420 Year (20) 442 (442) The same working can be done from the perspective of the lender, as they will also account for the loan that they have made using amortised cost (having classified the loan as an asset in loans and receivables ). Being an asset, the lender is earning interest, recognised in the income statement as income, and receiving cash. ANNUAL IMPAIRMENT REVIEW At each year end, all companies are required to assess whether there is any objective evidence of impairment of financial assets. If any such evidence exists, the entity is required to undertake a detailed impairment calculation to determine whether an impairment loss should be recognised (see Example 4). DEBT OR EQUITY When a company wishes to raise finance, it can do so by issuing debt or equity. The classification of the instruments issued into one of these two categories is important, as it has a direct impact on the debt to equity ratio of the company (the gearing ratio) and therefore on the perception of the company s risk. The fundamental principle to be applied is that a financial instrument issued by a company should be classified as either a debt or an equity instrument according to the substance of the contract, not its legal form. The company must make the decision at the time the instrument is initially recognised. A debt is defined in terms of there being an obligation to transfer cash or similar, and an equity instrument if there is no such obligation. Accordingly, it should be noted that redeemable preference shares and cumulative preference shares are both examples of instruments that are, in substance, debts and should be accounted for as such, ie as a liability measured at amortised cost, with the effective rate of interest being charged to income as an expense. Debt and equity The issue of convertible loan stock is, however, an example of a compound financial instrument as, from the issuer s perspective, the one piece of paper contains both a liability and an equity component. Convertible loan stock will contain an embedded derivative, ie an option that allows the holder to be repaid in shares rather than cash. With compound financial instruments, it is necessary to split the debt and equity elements at inception. The debt element is measured at the present value of the future cash flow, and the equity element (the value of the option) can be measured as the balancing figure (see Example 6). EXAMPLE 2 Available-for-sale: Tobago Tobago purchased an investment in shares for $10,000. Transaction costs incurred were an additional $500. At the year end, the fair value of the investment had risen to $15,000. Shortly after the year end, the asset was sold for $16,000. Explain the accounting treatment on the basis that the investment is classified as available-for-sale.

5 page 52 student accountant NOVEMBER/DECEMBER 2008 EXAMPLE 3 Amortised cost: Ryland Ryland has raised finance by issuing $200,000 4% debentures at par that will be redeemed in two-years time at a premium of $16,640. The effective rate of interest is 8%. Discuss the accounting implications of this financial instrument over its two-year life. EXAMPLE 4 Impairment and amortised cost: Lagos Lagos made a three-year loan of $10,000 on 1 January 2005 to a customer, requiring that the customer pay a simple interest rate of 10% on an annual basis, and that the principal sum of $10,000 be repaid at the end of three years. The effective rate of interest is also 10%. At the current year end of 31 December 2006, all due payments have been received as expected, but the borrower is in financial difficulty. It is now estimated that the only future cash flow will be $5,000 in one-year s time, ie three years after the date of the original advance. Discuss the accounting implications of this financial instrument over its three-year life. EXAMPLE 5 Derecognition of financial assets: Kashmir Kashmir has cash flow problems and has arranged to assign various invoices with a face value of $100,000 to a factor, in return for $85,000. All the invoices selected are from long-standing customers and are due to be collected some six months later. The factor has insisted that Kashmir guarantees to refund the face value of any invoices that have not been collected with three months of their due date. Explain the accounting treatment of the proceeds received, and the circumstances that will lead to the derecognition of the receivables from the statement of financial position (balance sheet). EXAMPLE 6 Split equity accounting for compound financial instruments: Yunan Yunan has raised finance by issuing a two-year, $100,000 convertible loan stock at par with a coupon rate of 2%. The effective rate of interest is 8%. Explain and illustrate the accounting treatment of this financial instrument over its two-year life. EXAMPLE 2 SOLUTION Available for sale: Tobago The financial asset is initially recognised when Tobago becomes a party to the purchase contract, and will be initially measured at the fair value of consideration given. This will include the transaction costs: DR Financial asset $10,500 CR Cash $10,500 At the year-end, financial assets that are classified as available-for-sale have to be remeasured at fair value, with the changes being taken to equity. With a fair value of $15,000 and a carrying value $10,500, the gain to be recognised is $4,500: DR Financial asset $4,500 CR Equity reserves $4,500 On the disposal of the investment, proceeds are received in cash and the asset with its carrying value of $15,000 is derecognised. However, the gain recognised in income will not simply be the difference, as it will include the balance of the revaluation surplus previously parked in equity: DR Cash $16,000 CR Financial asset $15,000 DR Equity reserve $4,500 CR Income $5,500 EXAMPLE 3 SOLUTION Amortised cost: Ryland On the raising of the loan, the company needs to recognise a financial liability. The company is a party to a contract because it has borrowed $200,000. The liability is initially recognised at the fair value of the consideration that has been received, ie $200,000. The liability is classified and subsequently accounted for at amortised cost. This means that the income statement will reflect the effective rate of interest of 8% being charged. Because the coupon rate is only 4%, the annual cash paid is $8,000 (4% x 200,000) but the finance cost must reflect the actual effective rate of interest of 8%, ie the finance cost does not comprise just what is paid each year but also the premium on redemption as well. Accordingly, the charge to profit in the first year is $16,000. The liability will be extinguished after two years when the loan is repaid with the premium: Opening Finance Cash paid Closing balance 8% 4% on nominal value balance at year end Year 1 200,000 16,000 (8,000) 208,000 Year 2 208,000 16,640 (8,000) 216,640 (216,640) EXAMPLE 4 SOLUTION Impairment and amortised cost: Lagos On 1 January 2005, Lagos needs to recognise a financial asset. The company is a party to a contract because it has lent $10,000. The asset is initially recognised at the fair value of the consideration that has been given, ie $10,000. The asset is classified as loans and receivables, as the company originated the loan, and it will therefore be subsequently accounted using amortised cost, ie the income statement will reflect the effective rate of interest of 10% being earned. At the 31 December 2006, the current year end, the asset has a carrying value of $10,000 but is subject to an impairment review. The recoverable amount is the present value of the future expected cash flow, which is $5,000 in one year s time discounted by 10%, equalling $4,545, thus an impairment loss of $5,455 arises and has to be charged to income. Impairment review at 31 December 2006: Carrying value $10,000 Recoverable amount $4,545 (5,000 x 1/1.1) Impairment loss $5,455

6 page 53 In the year to 31 December 2007, the asset will continue to be accounted for using amortised cost and so the income statement will enjoy the recognition of interest receivable of $455 (being 10% x $4,545) before being settled at $5,000 at the year end. EXAMPLE 5 SOLUTION Derecognition of a financial asset: Kashmir If we were to simply account for the legal form of the factoring then as the invoices have been assigned (ie sold), the debtors would be derecognised, and as the invoices have been sold for less than their book value, a loss arises of $15,000 that is recognised in the income statement: DR Cash $85,000 CR Asset $100,000 DR Income $15,000 However, as accountants we should be looking to account for the substance of the transaction in order to show a true and fair view. While the legal title may well have passed in this transaction, the risk associated with the debtors has not. The major risk associated with debtors is the risk of default, ie bad debt. If this happens then Kashmir has guaranteed that it will refund the factor the face value of the invoice, in other words the amount advanced plus interest. In reality, the cash received has the real potential of having to be repaid and so represents a loan. The correct accounting treatment is to keep the asset in the accounts until the risks and rewards have passed and this will only arise in six months time when the factor collects the debts. The correct accounting treatment for the money received is: DR Cash $85,000 CR Loan $85,000 EXAMPLE 6 SOLUTION Split equity accounting for compound financial instruments: Yunan The issue of convertible loan stock is the issue of a hybrid financial instrument as it contains both debt and equity elements. It is not just a simple debt. Convertible loan stock contains an embedded derivative the option to convert the debt to shares and as such it is necessary to account separately for the debt and the equity. This is known as split equity accounting. The debt element is the obligation to repay cash and this is measured at the present value of the future cash flow. This can be ascertained as $89,301, with the equity element of $10,699 being simply the balancing figure and will be taken to reserves. The debt is then to be accounted using amortised cost so that the finance cost is based on the effective rate of interest and not just the cash paid. The finance cost in the first accounting period should be $7,144, and the year-end liability at the end of the first year should be $94,445. Working to calculate the present value of the future cash flow: Year 1 2% x 100,000 2,000 x 1/1.08 1,852 Year 2 102,000 x 1/ ,449 Debt 89,301 Equity Balancing figure 10, ,000 Working showing the amortised cost accounting on the debt element: Opening Finance Cash paid Closing balance 8% 2% on nominal value balance at year Year 1 89,301 7,144 (2,000) 94,445 Year 2 94,445 7,555 (2,000) 100,000 Tom Clendon is a financial accounting lecturer at Kaplan Financial