Financial Reporting, Topic Area 3 Financial Instruments

Transcription

1 Sample Q&A Financial Reporting, Topic Area 3 69 short questions and answers to drill the narrative and numerical aspects of the topic The Q&A will work best if you cover the answer and actively attempt to answer the question fully (which may include calculations and written work). Repeat the questions until the principle/information sinks in. This sample includes various comments in the margins to highlight the key aspects of our Q&As. These comments are not present in the full versions of the Q&As. The full version contains analysis of past paper mark distributions over the 2009 to 2012 period to show you where to concentrate your efforts. Thank you for your interest in our materials. Please use the Contact page at if you have any questions. Best wishes for your examinations! All the best, The ACA Simplified Team

2 Topic Area 3 Financial instruments Simple, uncluttered presentation, allowing you to focus on the questions Q3.e1 Define a financial instrument A3.e1 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 All answers are provided immediately below questions no more wasting time flicking to the back for the answer Plenty of white space in the margins for your own notes Q3.e2 Is a non-derivative settled in terms of a fixed number of the entity s own equity instruments a financial asset? A3.e2 No. If the instrument is a non-derivative and settled by a fixed number of the entity s own equity instruments, it is simply an equity instrument, not a financial instrument. If the instrument is a non-derivative and settled in a variable number of the entity s own equity, then it is a financial instrument. All questions are numbered, allowing you to make a note of tricky questions and drill these more Q3.e3 An entity enters into a contract under which it will receive 10,000 of its own shares. Is this a financial asset or an equity instrument? A3.e3 Equity instrument. The number of shares to be received is fixed and the instrument is not a derivative. Q3.e4 An entity enters into a contract under which it will receive its own shares to the value of 10,000. Is this a financial asset or an equity instrument? A3.e4 Financial asset. The number of shares to be received is variable and the instrument is not a derivative. All questions are short and designed to be completed in 5 minutes or less, leaving you time to revisit the point many times before the exam 2

3 Q3.e5 A contract is a derivative which will be settled for a variable amount of cash for a fixed number of the entity s own equity instruments. Is the contract a financial asset or an equity instrument? A3.e5 A financial asset. There is variability here which prevents it being an equity instrument. Q3.e6 State the 3 defining characteristics of a derivative. A3.e6 1. Value changes in response to an underlying variable 2. No or small initial investment, compared to the investment which would be required in the underlying 3. Settled at a future date Q3.e7 Company A issued 2,000 warrants for 2 each. Each warrant gives the holder the right to acquire a new ordinary share in Company A for 20 at any time in the next 5 years. At the year end, the FV of a warrant was 9. Categorise the warrant and state the journals required. 3

4 Journals given to illustrate underlying points and impact on SFP and IS A3.e7 Topic Area 3 Equity instrument. The warrants are a derivative but, more importantly, the number of shares to be issued is a fixed amount. Therefore we can enter the amounts into equity, rather than as a financial liability. Journals Dr Cash (2,000 x 2) 4,000 Cr Equity - shares to be issued 4,000 Ignore the FV of 9 - that is a matter for the holder of the warrant Q3.e8 IAS 32 Financial instruments: presentation is applicable to all financial instruments, with 3 exceptions. State the 3 exceptions. A3.e8 IAS 32 does NOT apply to 1. Subsidiaries 2. Associates 3. Joint ventures In summary, group situations are outside the scope of IAS 32 Q3.e9 Should redeemable preference shares be recorded as a financial liability or within equity? A3.e9 Following substance over form, redeemable preference shares are akin to a loan (they have a redemption date) so are a financial liability, not equity. Q3.e10 What is split accounting? To what type of financial instrument is this relevant? 4

5 A3.e10 Split accounting separates the elements of convertible debt based on their substance. The obligation to pay annual interest results in a type of loan, and therefore this element is recognised as a financial liability. The remaining element of the convertible instrument relates to the redemption into shares. Since this relates to shares (and the number of shares is known in advance), we are looking at an equity instrument for this slice. Q3.e11 Provide the journals for the following share issue: Issue of 100,000 1 shares, for 2.50 in cash Professional fees of 50,000 are incurred on the issue and are taxdeductible Tax rate is 40% Internal management costs involved in the share issue are 25,000 A3.e11 Note: we can deduct the transaction costs from equity. We deduct them net of the tax saving because the tax saving hits the P&L. We ignore internal management costs as these would be incurred in any event. Cash paid is 250,000 Tax saving is 50,000 x 40% = 20,000 Dr Cash 250,000 Dr Tax liability 20,000 Dr Share premium 30,000 deduct professional fees net of tax Cr Cash 50,000 professional fees paid Cr Share capital 100, ,000 x 1 nominal Cr Share premium 150, ,000 x Net impact on share premium is an increase of 120,000 5

6 Q3.e12 Show the split accounting of the following bond: Issue of 10,000 6% convertible bonds at par of 100 Each bond is redeemable at par or convertible into 4 shares in 2 years The market rate of interest for similar debt without the conversion option is 8% A3.e12 The value of the bonds is 100 x 10,000 = 1m Annual interest is based on the nominal amount of 6%, so 60,000 per year Always discount at the market rate of interest EXCLUDING the conversion option So discount the cash flows at 8% In this case, there will be three cash flows: 60,000 interest in year 1, 60,000 interest in year 2, and 1,000,000 redemption in year 2 The PV of these flows gives us the liability element All elements of the question are fully explained. No figures are introduced without explanation no more guessing at how figures have been arrived at The balancing figure is the equity element Cash 6% 8% PV Year 1 60,000 1/ ,556 Year 2 1,060,000 1/1.08/ ,779 Exam tips provide useful tricks and hints to squeeze out a few more marks, based on our experience of preparing for and sitting past papers Liability element 964,335 Equity element Balancing figure 35,665 (B) Total proceeds 1,000,000 Exam tip - there will be impacts on the financial statements in the intervening period before conversion: profitability/income statement finance cost on the unwinding of the liability element statement of financial position liability element will increase due to unwinding, increasing gearing 6

7 Q3.e13 A company repurchases its own shares (purchase of Treasury shares). State the 4 aspects of the treatment of Treasury shares. A3.e13 Treasury shares are: 1. deducted from equity (i.e. shown as a debit balance in equity) 2. no gain or loss in the income statement on purchase, sale, issue or cancellation 3. consideration paid or received is put directly through equity 4. amount held as Treasury shares disclosed in either in SFP or notes to SFP Q3.e14 State the 4 potential classifications of financial instruments. A3.e14 1. Fair value through profit or loss (FVtPL) 2. Loans and receivables (L&R) 3. Held-to-maturity (HTM) 4. Available-for-sale (AFS) Q3.e15 When should a financial instrument be recognised? A3.e15 When an entity enters into contractual provisions Exam tip - there is usually a mark for very obvious statements on recognition and financial instruments are no exception 7

8 Q3.e16 Define the FVtPL category. When is it used? A3.e16 Used when instruments are held for trading i.e. the aim is make a profit from short term trading. Includes derivatives *Distinguish held for trading (FVtPL) from available for sale (AFS) - the latter just means that the instrument could be sold, not that it is being held with the intention of short term sale Q3.e17 Define the L&R category. When is it used? A3.e17 Instruments with fixed or determinable payments, not quoted in an active market. The unquoted characteristic is key here. Q3.e18 Define the HTM category. When is it used? A3.e18 Instruments with fixed or determinable payments and fixed maturity for which there is a positive intention to hold to maturity. Includes quoted securities and instruments. Distinguished from L&R category by being quoted and/or given the intention to hold to maturity. Q3.e19 Define the AFS category. When is it used? 8

9 A3.e19 Instruments not in the other three categories. Exam tip - there are usually easy marks for saying why an instrument is or is not part of a particular category. L&R is usually the rarest, and can be dismissed quickly if the instrument is quoted. HTM is a common possibility and can be dismissed quickly if there is no positive intention to hold all the way until maturity. Then if not held for trading (FVtPL), the instrument will almost certainly be AFS. Q3.e20 Explain the tainting rule. When does it apply? To which type of instrument does it apply? A3.20 This rule applies only to the HTM category. Instruments are designated into this category on the basis that they will be held to maturity. If this proves not to be the case, the entity has miscategorised the instruments and, as punishment, is not allowed to use the category again in the current period or next 2 periods. Q3.e21 At what value are financial instruments initially recognised? A3.e21 Fair value. Q3.e22 Provide the journals relating to initial recognition and year end in relation to the following instrument. In order to secure marketing benefits, an entity offers a customer an interest free loan of 5,000 for two years, when the market rate of interest is 6%. 9

10 A3.e22 Initial recognition Discount the loan to its fair value (i.e. a market equivalent) and recognise the loss in the IS as a finance expense. 5,000/1.06/1.06 = 4,450 Dr Loan (Asset) 4,450 Dr Finance expense IS 550 Cr Cash 5,000 At the year end Recognise finance income at 6% over the year on the 4,450 Essentially, we are recognising an upfront loss and then unwinding the discount back up over the two years so that it is equal to 5,000 when the loan is repaid Dr Loan (Asset) 267 Cr Finance income - IS 267 Asset will carry at 4, = 4,717 at the year end. After another year of interest income next year, this will be worth 1.06 x 4,717 = 5,000 Q3.e23 At each subsequent year end, instruments at FVtPL are remeasured to FV. Do we allow for transaction costs on these interim remeasurements? A3.e23 No - ignore any transaction costs on interim valuations. Exam tip - don t just ignore the costs: explain that they are not taken into account. That will get you more credit. 10

11 Q3.e24 When instruments at FVtPL are sold, transaction costs such as professional fees are likely to be incurred. Do we allow for transaction costs on sale? A3.e24 Yes - in contrast to the situation above, we do take transaction costs into account on the disposal. Q3.e25 Explain the potential impact of using the FVtPL classification on the 3 key financial perspectives. A3.e25 Using a fair value approach introduces volatility into the income statement as the values of assets/liabilities fluctuate. This may impact on profitability and earnings per share. The statement of financial position may also be volatile as the value of assets and liabilities fluctuates. This will affect gearing ratios. Cash flows are unaffected by the recognition method. Q3.e26 Define effective interest rate (EIR) A3.e26 The EIR exactly discounts estimated future receipts from the instrument back to the net carrying amount. In other words, the EIR creates a link between future cash flows and current carrying amount in the accounts. Applying the EIR to the carrying amount will therefore correctly amortise the asset/liability back up to the eventual cash receipt. It will also allocate income/expense on a systematic basis, taking into account all the cash flows and so is used for accrual accounting purposes. Q3.e27 When we measure an asset/liability at amortised cost, does the amortised amount (income/expense) hit the IS or the OCI? 11

12 A3.e27 IS. Don t confuse amortised cost amounts with changes in FV on AFS assets. Q3.e28 What are the 3 elements of amortised cost (apart from the EIR)? A3.e28 1. The initial amount 2. less any repayments (cash) 3. plus any amortisation (based on EIR) This gives the amount carried forward Q3.e29 Which leads to more volatility in the IS: amortised cost or FVtPL? A3.e29 FVtPL. In fact, if we are using amortised cost and there is no impairment or change of terms, we can precisely calculate ALL future income statement amounts just from knowing the initial amount, repayments and the EIR - nothing can change. Q3.e30 How is the L&R category held: at amortised cost or FVtPL? A3.e30 Amortised cost. Q3.e31 What do we do to AFS assets at the end of each reporting period? A3.e31 Measure at FV at the end of the reporting period. 12

13 Q3.e32 Where are gains and losses on AFS assets kept? A3.e32 Any gains or losses are recognised in OCI, not IS. They are held in equity in the AFS Reserve until the asset is actually sold. Upon sale, the amount in equity is transferred to the IS It is possible for a negative balance to exist in the AFS Reserve provided that this does not represent a permanent loss in value. Exam tip - it is very common indeed for AFS assets (and the recycling of balances) to be tested because there are various journals and issues to look at. Q3.e33 Where possible, calculations use small numbers to illustrate the basic principle more easily allows you to concentrate on the underlying point, not the number of zeroes to use An AFS asset is acquired for 100. At the end of year 1 it has a fair value of 120 and potential transaction costs of 10. At the end of year 2 it has a fair value of 110. The entity decides to sell the asset at the end of year 2 as the fair value has fallen and receives 110 cash. Give the journals for year 1 and 2. 13

14 A3.e33 Recognition Dr Financial asset 100 Cr Cash 100 Year 1 Asset has gained 20 in fair value. Ignore transaction costs on interim revaluations. Dr Financial asset 20 Cr OCI - AFS reserve 20 Year 2 Asset has loss 10 in fair value. It is then sold. Split these two transactions Loss in FV Dr OCI - AFS reserve 10 Cr Financial asset 10 The AFS reserve will now stand at 20 Cr less 10 Dr = 10 Cr net The financial asset will now stand at 100 original value plus 20 Dr less 10 Cr = 110 Dr net Disposal Dr Cash 110 Dr OCI - AFS reserve 10 net amount left in Cr Financial asset 110 Cr Income statement 10 We effectively transfer the net balance in the AFS reserve into the income statement. Q3.e34 If an AFS suffers a loss in value, where is this always recognised? A3.e34 This is a trick question. If the loss in FV is temporary, it hits the AFS reserve. If the loss is permanent, it is an impairment loss and hits the IS. There is no place where the loss is always recognised. 14

15 Q3.e35 Is the AFS classification more or less volatile than FVtPL? A3.e35 AFS is usually less volatile as gains and losses do not hit the IS every year - only the net change, taking into account all the years, hits the IS on disposal. However, if the AFS asset is continually increasing or decreasing in value, the IS will take a large one-off hit on disposal whereas it would have taken an increase or decrease gradually over time under the FVtPL category. In this sense, it could be argued that an AFS asset leads to a more volatile P&L. Note that AFS gains are held in equity and so have the potential to affect gearing measures each year. As always, cash flows are not affected by the categorisation. Exam tip - the cash flow point can always be made and so is not very interesting - but is still worth a mark! Q3.e36 Which 2 financial asset categories are measured using FV and which are measured using amortised cost? A3.e36 FV - FVtPL, AFS. However, under AFS we do take account of the EIR when looking at changes in the carrying amount during the year, BEFORE the adjustment to year end FV. Amortised cost - L&R, HTM Q3.e37 Unlike the situation with financial assets, there is only one type of financial liability which is measured at FVtPL. Name it. A3.e37 Derivatives 15

16 Q3.e37 How are financial liabilities other than the type noted in Q3.e38 measured? A3.e37 Amortised cost, applying the EIR method Q3.e39 (Mar 11) Which is the only financial asset category to result in an entry within equity? A3.e39 (Mar 11) AFS this results in an AFS Reserve if the asset gains FV by the year end. Q3.e40 An entity buys unquoted equity shares in Purchased Ltd. Initially there is no reliable estimate of its fair value. At the end of the reporting period, Purchased Ltd offers a large number of shares for sale to a variety of buyers. A fair value therefore becomes available. Explain the treatment of the unquoted equity shares by the entity. 16

17 A3.e40 Initially, the shares are recognised as cost as there is no alternative, reliable estimate. These are not a loan and receivable (L&R) as shares do not have an expiry date. For the same reason, they cannot be held to maturity (HTM). So unless the shares are held for trading, they should be classified as AFS. When a reliable valuation becomes available, the holding should be remeasured at fair value. Exam tip - there may be an ethics overlap here as it would be unethical to maintain the recognition at cost if a reliable alternative estimate is indeed available Q3.e41 Do we allow for block holdings when valuing shares? i.e. if Big plc holds 70% of the shares in Purchased plc and is interested in acquiring shares held by Mr Small, which amount to 6% of the company and so would give Big plc significant control (75% or more), the shares may be worth more to Big plc than to any other potential purchaser. Do we allow for this premium when assessing fair value? A3.e41 No, we do not allow for the control premium. We simply use the published price, per IAS 39. Q3.e42 Give an example of a transaction which may appear to result in derecognition of a financial asset but in which the asset should not in fact be derecognised. 17

18 A3.e42 There are many possible examples where substance over form would suggest that the substance of a transaction is not really a derecognition. For example, a sale combined with an agreement to repurchase the asset at a later date at a fixed price is essentially a form of borrowing: the entity gets cash now and agrees to repay it later. The difference in prices is essentially, therefore, a finance cost. Exam tip - this could overlap with an ethical issue, in cases where an AFS asset is sold in order to artificially recycle some AFS reserve gain into the IS. Q3.e43 What is the underlying principle at play in Q3.42? A3.e43 Substance over form. Q3.e44 When should a financial liability be derecognised? A3.e44 When an entity discharges the obligations specified in the contract or they expire. Q3.e45 An entity purchases a financial asset for 30,000. At the next year end, the FV of the asset is 34,000. The following year, one quarter of the asset is sold for 10,000 Assuming the asset is held for trading, calculate the profit or loss and carried forward amounts. 18

19 A3.e45 If the asset is held for trading, we are looking at a FVtPL situation. We therefore simply recognise a gain based on the difference between 10,000 proceeds and ¼ of the carrying amount (1/4 x 34,000 refreshed FV carrying value = 8,500). This is gain of 1,500. Going forward, the entity now has ¾ of the 34,000 FV remaining so carries the asset at 25,500. Q3.e46 An entity purchases a financial asset for 30,000. At the next year end, the FV of the asset is 34,000. The following year, one quarter of the asset is sold for 10,000 Assuming the asset is Available for Sale (AFS), calculate the profit or loss and carried forward amounts. A3.e46 We have the same data as Q3.45 but the classification as AFS is more complicated. The asset was acquired for 30,000 but was revalued to 34,000 at the previous year end. We therefore have 4,000 in the AFS reserve i.e. not yet in the IS. We are now selling ¼ of the asset, so we can recycle ¼ of that gain ( 1,000) into the IS. The IS therefore takes the 1,500 gain identified in the same manner as with the FVtPL asset i.e. proceeds less ¼ of the carrying amount, plus the 1,000 recycled, for a total gain of 2,500. Going forward, the entity will have an AFS reserve of ¾ x 4,000 = 3,000. It also retains ¾ of an asset which cost 30,000 = 22,500 within the SFP. So the total retained is 3, ,500 = 25,500. Note how the total carried forward ( 25,500, or 3,000 AFS plus 22,500 share of cost) is the same under the AFS method as under the FVtPL, but under AFS, 3,000 of this sits in the AFS reserve. This could impact on some ratio measurements. Q3.e47 Does impairment of financial instruments take into consideration: (a) events which have occurred already (b) future events? 19

20 A3.e47 (a) Yes (b) No Impairment is only based on past events, not future possibilities. Do not confuse impairment with going concern analysis, which could legitimately consider events which have not yet occurred. Q3.e48 Briefly explain the treatment of impairment in the case of: (a) assets held at FVtPL (b) assets held at amortised cost. A3.e48 (a) Impairment charge hits the IS. The impairment charge is simply equal to the change in FV. In the case of an AFS asset, ensure that the loss in value is genuinely permanent because a temporary decline can just be held in the AFS reserve in equity. (b) Impairment charge hits the IS. The impairment charge is the difference between the existing carrying amount at amortised cost and the PV of new future cash flows discounted at the original EIR. Exam tip - do not change the EIR you are using - this may not sound sensible if you have new data, but that is what the standard requires. 20

21 Q3.e49 Calculate the treatment of the following impairment: Loan of 1,000 at 7% per annum interest. Repayable in 2 years at a premium so EIR higher at 8%. Payment of the first year s interest is received on time but the borrower is in financial difficulty. The entity therefore changes the terms of the loan so that the loan is repayable in 4 years (i.e. a 3 year extension) at a premium of 100. No interest is paid in the meantime. The asset was being carried at 1,010 in the accounts at the time of the renegotiation. A3.e49 First, find the PV of the new flows using the original EIR of 8%. No interest is being paid now, so the only flow is 1, premium = 1,100 receivable in 4 years. 1,100/(1.08^4) = 809 Second, compare this new value with the carrying amount in the accounts. The difference becomes the impairment loss in the IS, recognised immediately. 1, = 201 Going forward, the asset is now held at 809 and interest income of 809 x 8% = 65 should be recognised in IS, amortising the asset up to = 874 at the end of the next reporting period. 21

22 Q3.e50 State whether reclassification of financial assets is permissible or impermissible in the following scenarios. If permissible, state whether reclassification is required. If required, state the new category or categories. 1. An entity sells more than an insignificant amount of HTM investments. 2. There is a change in future intention regarding certain HTM investments. 3. A financial asset acquired for trading purposes but no longer held for these purposes. 4. A financial asset initially classified as AFS 5. An equity instrument no longer held for trading 6. A derivative 22

23 A3.e50 (1) Permitted and required. Here the tainting rule takes effect because the entity has sold assets which it had previously said would be held to maturity. Reclassify into AFS and taken any gain/loss on reclassification into the AFS reserve, to be recycled on sale. (2) Permitted and required. Reclassify into AFS and taken any gain/loss on reclassification into the AFS reserve, to be recycled on sale. (3) Permitted if the asset meets the criteria for L&R (i.e. unquoted) and there is an intention and ability to hold the asset for the foreseeable future (not the same thing as a positive intention to hold to maturity, as applied to the HTM category) Reclassified into L&R (4) Permitted if the asset meets the criteria for L&R (i.e. unquoted) and there is an intention and ability to hold the asset for the foreseeable future (not the same thing as a positive intention to hold to maturity, as applied to the HTM category) Reclassified into L&R (5) Impermissible. Equity instruments should never be reclassified so it is not relevant that the instruments are no longer held for trading. (6) Impermissible Q3.e51 What are the overall objectives of IFRS 7 Financial instruments: disclosures? A3.e51 The overall objective is to provide information on risk relating to financial instruments. Specifically, IFRS 7 aims to enable users to evaluate: significance of financial instruments for entity s financial position and performance, and nature and extent of risks relating to financial instruments 23

24 Q3.e52 IFRS 7 risk disclosures split into qualitative and quantitative elements. Summarise the qualitative elements. A3.e52 Qualitative elements focus on exposure to risk, how the risk arises and the entity s policy on managing those risks. Q3.e53 Explain some of the differences between IFRS and UK GAAP in respect of financial instruments. A3.e53 There are no differences. This is perhaps the only occasion where financial instruments are simple. Q3.e54 Suggest some ways in which ethical issues arise in respect of financial instruments and related accounting. A3.e54 There may be pressure to classify into HTM or AFS in order to reduce volatility in the financial statements, either by ignoring changes in FV (under HTM) or holding changes in FV outside the IS (under AFS). Determining FV is judgemental - accountants might be forced into including a high FV to boost earnings. Financial instruments have a big impact on the IS and SFP so can affect many performance measures and analysts findings based on ratios. There may be judgement calls in relation to substance over form regarding complex transactions and correct classification. Decisions must be appropriately supported and documented at the time. 24

25 Q3.e55 On 1 January 2009, Issuer plc issues 200, % convertible redeemable preference shares. Issue costs of 5,000 were incurred. The preference shares are redeemable at par in 2013 or convertible into 10,000 new ordinary 1 shares that that time. The preference dividend is paid on 31 December each year. The interest rate on similar financial instruments without a conversion option is 8%. Explain and calculate the treatment of preference shares. 25

26 A3.e55 1) Split the liability and equity components on recognition. Liability element is PV of cash flows and equity is the amount required to balance to the initial recognition. In this case, we deduct the 5,000 transaction costs from the initially recognised amount to give a net recognised liability of 195,000. Exam tip - always Debit transaction costs on financial instruments, whether assets or liabilities (unless they are at FVtPL, in which case still a Debit but to the IS, not SFP). Therefore transaction costs add to the value of an asset and reduce the amount of the liability. Think of the double entry: a Credit to Cash or Payables the Debit hits the asset or liability account Payments Amount 8% (rate for PV 6% instrument w/out option) , , , , , , , , , , , , Liability 184,032 Equity balancing amount 10,968 Total 195,000 (The total is the 200,000 raised less transaction costs.) 2) Interest expense in the year (IS) will be the unwinding of the discount on the liability element at the 8% used to discount it, so 8% x 184,032 = 14,723. Add this to liability and deduct cash received to give year end liability (SFP) of 184, ,723-12,000 = 186,755 3) Entries for the year Finance cost (IS) 14,723, as above Borrowings (SFP) 186,755 Equity (SFP) 10,968 Interest paid (SCF) 12,000 Proceeds from issue (SCF) 195,000 Don t forget to include the above listing it will be worth quite a few marks but you will not normally be reminded to include it. Q3.e56 Company plc reacquires 25,000 of its own 1 ordinary share for 30,000 cash. The shares were originally issued for 27,000. Explain and calculate the treatment of the share repurchase. 26

27 A3.e56 Dr Shares repurchased (equity) 30,000 Cr Cash 30,000 The existing share capital and share premium amounts are not relevant. No gain or loss is recognised. Q3.e57 Purchaser plc acquired 20,000 shares in Acquired plc which has an issued share capital of 45m shares. Shares are quoted at at acquisition and at the reporting date. Explain and calculate the treatment of the share repurchase. A3.e57 This is not a subsidiary or associate scenario as the shares purchased do not give any significant holding. Therefore apply IAS39. Always use the lower of the two given prices, so recognise using 50 value and revalue at year end using 40 value. Therefore, initial recognition at 50 x 20,000 = 1,000,000. Revalued at year end to 40 x 20,000 = 800,000 If held for trading (FVtPL), the loss hits the IS. If AFS, the loss is held in the AFS reserve and put through OCI, unless the loss is permanent, in which case it is an impairment and so goes straight to the IS. Q3.e58 Purchaser plc acquires an interest rate swap for 500,000 on 1 December It is sold on 31 December 2009 for 650,000. Explain and calculate the accounting treatment. 27

28 A3.e58 An interest rate swap is a derivative. Therefore the only possibility (for the purposes of the FR exam) is FVtPL. The asset is recognised at 500,000. A gain of 150,000 is then recognised on sale on 31 December Recognition Dr Financial asset 500,000 Cr Cash 500,000 Disposal Dr Cash 650,000 Cr Financial asset 500,000 Cr IS - profit on disposal at FVtPL 150,000 Q3.e59 Issuer plc issued 40,000 warrants for 4 each, giving the holder the right to subscribe for one new ordinary share in Issuer plc in 3 years for 22 each. 3,000 of professional fees were incurred. Fees are tax-deductible at 30%. Calculate and explain the accounting treatment for Issuer plc. 28

29 A3.e59 The warrants are on Issuer plc s own equity and are settled for a fixed number of shares for a fixed amount of cash. Therefore they are an equity instrument. Fees net of the tax benefit are deducted from proceeds i.e 3,000 x 70% = 2,100 is deductible so 160,000-2,100 = 157,900 is added to equity. Journals Dr Cash 160,000 Dr Tax expense 900 tax deductible share of 3,000 Cr Equity - share warrants 157,900 Cr Cash 3, ,900 is shown as net proceeds from the share issue in the SCF. Note that the 900 tax saving is shown within this cash flow. Q3.e60 On 1 January 2010, Issuer plc issued 100,000 6% 1 preference shares at par, which was also their fair value. The shares are quoted in an active market and are redeemable at a premium of 4% on 31 December The value of one preference share on 31 December 2011 is 95p. The effective interest rate is 6.9%. Purchaser plc subscribes for all the shares issued by Issuer plc. Calculate and explain the accounting treatment as at 31 December 2011 if the shares are classified as held to maturity (HTM) by Purchaser plc. 29

30 A3.e60 Initial amount recognised 100,000 x 1 FV (=par) 100,000 Interest income at EIR of 6.9% (IS) 6,900 Interest received in cash at coupon rate of 6% (SCF) ( 6,000) Carrying amount at 31 December ,900 Q3.e61 Using exactly the same data as above, calculate and explain the accounting treatment as at 31 December 2011 if the shares as classified as held for trading by Purchaser plc. A3.e61 If held for trading, the asset is at FVtPL FV at year end 100,000 x 0.95 new FV 95,000 less initial amount recognised (as in previous question) ( 100,000) Reduction in FV ( 5,000) Carrying amount at 31 December ,000 Note - under the HTM classification in A3.67, we do not take account of changes in FV so we do not recognise any loss and hence there is an incentive to use this category. Finance income at 6% coupon (IS, SCF) 100,000 x 6% 6,000 Note - do not use the EIR re FVtPL - we are not using the amortised cost method so the EIR used in the amortised cost method is not relevant: just use the coupon rate. 30

31 Q3.e62 Using the same data as in the previous questions (reproduced below for convenience), calculate and explain the accounting treatment at 31 December 2011 if the shares are classified as available for sale. Data: On 1 January 2010, Issuer plc issued 100,000 6% 1 preference shares at par, which was also their fair value. The shares are quoted in an active market and are redeemable at a premium of 4% on 31 December The value of one preference share on 31 December 2011 is 95p. The effective interest rate is 6.9%. Purchaser plc subscribes for all the shares issued by Issuer plc. A3.e62 Initial amount recognised 100,000 Interest income at 6.9% EIR (IS) 100,000 x 6.9% 6,900 Interest received at 6% coupon rate (SCF) 100,000x6.0% ( 6,000) Change in fair value (balancing figure) ( 5,900) FV at 31 December 100,000x ,000 Note - this is very similar to the HTM calculation. The first three lines are identical. The only difference is that with the AFS we also take account of the fair value change and so need to have a balancing figure to show the loss between what we would have accounted for and what we need to include given the change in the market. If the FV were still 1 per share, the HTM and AFS calculations would give exactly the same answers. The 6,900 EIR interest is recorded in the IS and the 5,900 loss in FV hits the AFS reserve in equity. Q3.e63 Based on your calculations for Q3.60 to Q3.62, comment on the impact of the different classification as HTM, FVtPL and AFS. 31

32 A3.e63 Impact on cash flows is the same for all three alternatives. HTM gives the least volatile result. HTM does not consider the change in FV. HTM uses the amortised cost method. AFS is very similar to HTM, but with the addition of a movement to fair value at the year end. This does not hit the IS however, so AFS and HTM give the same IS impact (positive 6,900 from the finance income at EIR). Both AFS and HTM require use of both the EIR and coupon rate in the calculations. FVtPL is perhaps the outsider because it takes a different approach: the EIR is not used at all in the FVtPL calculation because we are not using the amortised cost method FVtPL results in a lower net income/gain in the IS because finance income is lower, being measured using the 6% coupon rate, not the 6.9% EIR and because we take the 6,000 loss in FV to the IS Also note that although FVtPL and AFS both revalue to FV at the year end, the loss in FV under FVtPL is lower at 5,000 than under AFS at 5,900. This is again because of the interest rates used because AFS adds on income at a rate of 6.9% EIR before deducting coupon interest received at 6.0%, leaving a net increase of 0.9% (i.e. 900) before the FV change is accounted for. On the other hand, FVtPL does not include any interest rates in assessing the FV change so it is a pure fall in value of 5,000. However, the larger AFS change is held over whereas the smaller FVtPL loss hits the IS immediately. Note - in this example, the EIR is higher than the coupon rate due to the existence of a redemption premium, meaning that the amortised cost must gradually brought up to a higher redemption amount. If EIR and coupon rate are the same, AFS and FVtPL loss in FV would be the same. 32

33 Q3.e64 (Dec 11) An entity took out a loan several years ago. The loan is currently carried at 1m. Annual cash interest of 100,000 is paid every year, on the final day of the reporting period. The effective interest rate is 6%. The entity decided to pay the loan off early, 6 months into the reporting period. Including a late payment charge, the total paid back to the bank was 1.2m. Explain the treatment. A3.e64 (Dec 11) This is a financial liability. It can be derecognised when the entity discharges the obligations specified in the contract or when those conditions expire. The entity has discharged obligations by repaying. This means that we simply find the carrying amount at settlement, compare this with the 1.2m repaid and the difference is the repayment penalty, recognised as a loss in the IS in the year. Note that the interest is paid on the final day of the year so was not paid in this case and therefore the 100,000 is not relevant to the calculation. Carrying amount 6 months into the year = 1m + ( 1m x 6% x 6/12) = 1.03m. Therefore the repayment charge was 1.2m m = 0.17m 33

34 Questions for more technical papers such as FR and Tax are split into Essential and Advanced questions, showing you where to concentrate Advanced questions Q3.a1 Topic Area 3 A financial instrument has a choice of settlement options, some of which would not result in it being considered an equity instrument. Is it possible for it to be categorised as an equity instrument? A3.a1 No. If there is a choice of settlement options, they must ALL result in it being an equity instrument if we are to categorise the instrument itself as an equity instrument. Q3.a2 There is a special rule in respect of the value at which equity instruments might be recognised? What is it? A3.a2 If the equity instrument does not have a quoted price AND it is not possible to estimate the value reliably, it should be measured at cost. Exam tip - this is a fairly common test. Look at whether the equity instrument relates to an unlisted company. If so, don t forget that the second rule - it must not be possible to reliably estimate a fair value using a valuation technique - before the cost recognition principle comes into play. Q3.a3 Provide some examples of disclosure requirements under IFRS 7. Note: You are unlikely to need to list all of these - just get a rough idea. 34

35 A3.a3 Carrying amounts of: HTM assets L&R assets AFS assets FVtPL assets and liabilities Liabilities held at amortised cost The fair values of each of the above should also be disclosed The above should be disclosed in the SFP or notes. Interest income and expense for financial assets and liabilities not measured at FV Gains and losses on each category of financial instrument Impairment losses for financial assets Disclosure of net gains or losses on financial assets and liabilities by class Full explanation of the accounting policies applied in recognising and measuring its financial instruments. Disclosures of both the qualitative and quantitative aspects of risks Sensitivity analysis, together with disclosure of the related methodology and whether the methodology is consistent with the prior period Q3.a4 IFRS 7 risk disclosures split into qualitative and quantitative elements. What 3 primary risk categories are included within the quantitative disclosures? A3.a4 Credit risk - risk that one party to the contract will cause a loss to the other Liquidity risk - risk that entity will struggle to meet financial liabilities Market risk - risk that FV or future cash flows will fluctuate because of changes in market prices 35

36 Q3.a5 Where are sensitivity disclosures relating to quantitative aspects of risk usually disclosed? A3.a5 In the Operating and Financial Review. 36