ACCA Paper P2. Financial Management. theexpgroup.com

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1 Thank you for downloading this extract from our ExPedite notes to accompany your free online Course in a Coffee Break. To download a free complete set of our ExPress notes please visit Good luck with your P2 studies. ACCA Paper P2 Financial Management For exams in 2010

This means that the scenarios in which they are tested are likely to be relatively straightforward.

2 Chapter 5 Financial Instruments START The Big Picture Although financial instruments appear frequently in the P2 exam, they are only at level 2 knowledge within the syllabus. This means that the scenarios in which they are tested are likely to be relatively straightforward. It s easy to spend too much time preparing for these accounting standards, since they cover a huge array of different possible transactions, from regular trade receivables to exotic currency and interest rate swaps. Page 5.1

3 The best way to approach study is to know: The four different classifications of all financial instruments The difference in fair value and amortised cost accounting The possible ways in which any gain or loss (whether on a financial instrument or not) may be reported in financial statements. If you are keen to take this as far as you can, then move on to study hedging, though this has generally only been worth a couple of marks in the exam. When used... Example... Example that can t be categorised this way Initial recognised value Year-end valuation method Gains or losses reported in... Held-to-maturity financial assets When have the ability and positive intention to hold a security to its stated maturity date. Investment in corporate bonds or government bonds. Ordinary shares, as no maturity date. Nothing can be HTMFA if the entity has reclassified any investment out of HTMFA in the preceding two years. Cost paid, including transaction costs. Amortised cost, less impairments. Impaired value estimated using revised cash flows, discounted at the original discount rate when the investment was purchased. Profit or loss Loans and receivables When have loaned a third party money (to a maturity date) or have an amount receivable (e.g. trade receivables). Originated loan to a third party (e.g. a bank lending a loan to a homebuyer). - Initial cash advanced, plus transaction costs. Amortised cost, less impairments. Impaired value estimated using revised cash flows, discounted at the original discount rate when the investment was purchased. Profit or loss Page 5.2

4 When used... Example... Financial asset or liability held at fair value through profit or loss Almost anything can be categorised as FVPL at its initial recognition (notably not debt issued by the entity itself). Securities held for trading will be classified as FVPL. Shares held for trading. Available-for-sale financial assets A catch-all category. Anything not in either of the other categories will be AFSFA. Typically, where investor stands ready to sell the security but has no immediate plans to. Shares held for intermediate term investment. Example that can t be categorised this way - - Initial recognised value Year-end valuation method Gains or losses reported in... Cash paid to acquire. Transaction costs immediately written off to profit or loss. Fair value. Best achievable market price, not deducting anticipated selling costs (though at the lower end of the bid ask spread). Profit or loss Cash paid to acquire. Transaction costs added to initial value of investment. Fair value. Best achievable market price, not deducting anticipated selling costs (though at the lower end of the bid ask spread). Initially gain or loss reported in equity until sold, when the gain or loss is recycled (ie reported again) in profit. Page 5.3

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6 KEY WORKING METHODS Recognition and derecognition The recognition criteria for financial instruments are slightly different to the recognition criteria in many other IASs/ IFRSs. The intention is to ensure that as many as recognised as possible, for as long as possible. They are recognised when the entity becomes party to the contract rather than when control is obtained. They are derecognised only when it s virtually certain that all the risks of a financial instrument have expired or have been transferred to another party. Fair value accounting Fair value essentially means market value. So if the market is acting irrationally, then fair value may lead to dysfunctional financial reporting. This is a recent criticism of fair value accounting techniques. Fair values are determined as: Best achievable market value (but not deducting expected transaction costs), or Valuation using discounted cash flows that consider all matters relevant (e.g. expected cash flows, timing of cash flows, credit risk, market interest rates, or Exceptionally if no reliable DCF valuation is possible, historical cost. Amortised cost For held-to-maturity financial assets, both the issuer and the holder of the financial instrument (e.g. bond) know all the cash flows and the timing of those cash flows. The market value at its issue is known, as is its market value at maturity, since a bond that pays $1,000 on a known date is worth $1,000 on that date! Any changes in market value in between the date of issue and the maturity date is therefore irrelevant as that gain or loss will not be realised. The easiest treatment is therefore to spread the total return over the bond over its total life. This is done using the effective rate, which is the total return on the bond. Page 5.5

This is the internal rate of return of all the cash flows. In the exam, you would be given the effective rate and be asked to calculate the figures in the financial statements.

The bond is due for redemption on 31 December 20x5 for $200,000 (plus the coupon payable on that date).

7 This is the internal rate of return of all the cash flows. In the exam, you would be given the effective rate and be asked to calculate the figures in the financial statements. EXAMPLE On 1 January 20x1, Cordelia Co issued a bond with a nominal value of $200,000, a coupon rate (ie cash paid) of 4% of nominal value. The bond is due for redemption on 31 December 20x5 for $200,000 (plus the coupon payable on that date). In reality, it s likely that the effective rate would be worked out using a spreadsheet and the IRR function, which is illustrated below. This means that by the end of the five year life of the bond, it has been transformed ( amortised ) from its initially recognised value to its redemption value of $200,000. Page 5.6

8 So the charge or credit to profit for finance costs/ finance income is determined using the effective rate. The difference between interest calculated using the effective rate and the coupon paid/ received is the rolled up interest, which is added to the value of the bond each year. Reclassication To prevent creative accounting, reclassifying from one category of financial instruments to another is strongly discouraged by IAS 39. If a material held-to-maturity financial asset is reclassified out of held-to-maturity financial assets, then: All other held-to-maturity financial assets must be immediately reclassified as available for sale, with immediate recognition of all gain or loss (paragraph 52, IAS 39). For that year and the two years thereafter, it is barred from classifying anything as held-tomaturity financial assets (paragraph 9, IAS 39). Impairments All financial assets held at fair value are automatically revalued for impairments. If a heldto-maturity asset appears to be impaired (e.g. if the credit risk increases a great deal), then the new impaired value must be calculated using: The revised expected cash flows and expected timing At the original discount rate. Note that discounting the revised cash flows at the new rate (which would be higher, as the risk has increased) would double count the risk factor and result in undervaluation of the asset. Page 5.7

Hedging Hedging has only occasionally been tested in paper P2 and then normally as a relatively minor adjustment in question 1. It is common in practice and useful knowledge.

9 Hedging Hedging has only occasionally been tested in paper P2 and then normally as a relatively minor adjustment in question 1. It is common in practice and useful knowledge. Becoming expert in hedging should not be a top priority for most students studying for paper P2, since it can take a lot of time to master for a relatively low profile in the exam itself. KEY WORKING METHODS Hedged item: The thing the enterprise is worried about changing in value, e.g.: Foreign currency investment Foreign currency payable Variable interest rate loan resulting in higher than expected cash outflows Forecast future major purchase in a foreign currency becoming unaffordable due to changes in the exchange rate. To remove or reduce this risk, the entity may buy something that is expected to move in value in the opposite direction to the hedged item. This counterweight is the hedging instrument and may be an almost infinite number of different financial instruments, though derivatives are common. Understanding the intricacies of how hedging relationships may be set up is not important for paper P2. It s useful to know how to account for movements in the hedged item and the hedging instrument. Page 5.8

10 Though three types of hedge are mentioned in IAS 39, there are only two accounting treatments for hedges, so there are basically two types of hedge: Fair value hedge The hedging instrument was taken out in order to protect against value changes of an item recognised in the SOFP. E.g. a foreign currency loan to protect against a foreign exchange change in value of a foreign currency receivable that is being shown in the SOFP. Cash flow hedge A hedge that is not a fair value hedge, broadly! This might be to protect against adverse movements in an item not in the SOFP yet. E.g. an entity may structure its business plan around buying a ship from a foreign ship builder, but it has not yet placed a binding order. As there is no binding order, there is no obligation, so there is no liability. The forecast/ intended transaction is not yet a liability, though the company will want to ensure that they can afford the expected future cash outflow. To protect against adverse exchange movements making the ship unaffordable, the entity may hedge the foreign currency exposure, e.g. buy buying a foreign currency forward contract. Accounting for hedges A fair value hedge is simple. Both the hedged item and hedging instrument will be in the SOFP and will record a gain and a loss. The accounting rules simply offset the gain on the hedged item with the loss on the hedging instrument, or vice versa. A cash flow hedge is a bigger challenge for the writers of the IAS! The hedging instrument will be a contract, so will be in the SOFP, but the hedged item will be an intention, so is not in the SOFP. Since the hedging instrument exists only because of the expected existence of the hedged item, the gain or loss on the hedging instrument is hidden in equity until the hedged transaction takes place. Page 5.9

Chapter 4 to 6 extract from our ExPress notes for use with the current video.

Chapter 4 to 6 extract from our ExPress notes for use with the current video. A full set of F2 ExPress notes can be downloaded free of charge at www.. Notes CIMA Paper F2 Financial Management Contents