Clas Notes7B Financial Assets and Liabilities (1).docx

**Financial Instruments - IFRS 9 & IFRS 7** **Definitions:** A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability. A financial asset is effectively a contractual right to receive cash~~.~~ A financial liability is a contractual oblig...

**Financial Instruments - IFRS 9 & IFRS 7** **Definitions:** A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability. A financial asset is effectively a contractual right to receive cash~~.~~ A financial liability is a contractual obligation to deliver cash~~.~~ Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Examples of Financial Assets are -- Financial Investments, Cash, Trade Receivables Examples of Financial Liabilities and Financial Equity -- Equity shares, Loans, Bonds, Convertible debentures, Preference shares. A financial derivative is an item, with little or no cost, whose value depends on another item. **Classifying Finance Raised as Equity / Liability should money we receive from investors be described as liability or equity?** Long term finance raised needs to be reported in the Balance Sheet, classified as Liabilities or Equity. If they could get away with it, companies would happily misreport finance raised as equity, thereby improving their gearing ratio. An instrument is reported as a liability if its substance meets the definition of a liability. Thus if finance raised creates an obligation to make future payments then it is a liability. - Repayable preference shares are classified as a Liability, whilst Non Repayable Preference shares are classified as Equity. - A convertible debenture is deemed to be partly a Liability and partly Equity. The liability component is the obligation to make future payments. The remainder is Equity. \- list the obligations ( assume repayment occurs rather than conversion to shares) \- In future years report this liability at amortised cost. Investors give us £40m and we give them convertible debenture certificates. It is a 3 year loan with annual interest 2%. After 3 years the loan can be changed into 20m ordinary shares. Similar non convertible loans are paying annual interest 10% This implies investors expect an 8% return from rise in share price on the convertible loan and so an overall return of 10% a year +-----------------+-----------------+-----------------+-----------------+ | Year | Obligations to | 'fair'cost = | Present Value | | | pay cash | 10% | | +=================+=================+=================+=================+ | Now | | | | +-----------------+-----------------+-----------------+-----------------+ | 1 | £40m x 2% = | / (1.10)^1^ | £0.73 | | | £0.8m | | | +-----------------+-----------------+-----------------+-----------------+ | 2 | £40m x 2% = | /(1.10)^2^ | £0.66 | | | £0.8m | | | +-----------------+-----------------+-----------------+-----------------+ | 3 | £40m x 2% = | /(1.10)^3^ | £0.60 | | | £0.8m | | | +-----------------+-----------------+-----------------+-----------------+ | 3 | ~~Hand over | /(1.10)^3^ | £30 | | | shares~~ | | | | | | | | | | ~~20m x £?~~ | | | | | | | | | | Repay £40m | | | +-----------------+-----------------+-----------------+-----------------+ | | | Liability | £31.99 | +-----------------+-----------------+-----------------+-----------------+ | | | Equity | £8.01 | +-----------------+-----------------+-----------------+-----------------+ | | | Total | £40 | +-----------------+-----------------+-----------------+-----------------+ For 6 Zap Year Cash obligation 9% fair cost Present Value ------ ----------------- -------------- --------------- Now 1 50 x 6% = £3 /(1.09)^1^ 2.75 2 50 x 6% = £3 /(1.09)^2^ 2.52 3 50 x 6% = £3 /(1.09)^3^ 2.31 3 Repay £50 /(1.09)^3^ 38.61 Liability 46.18 Equity 3.82 **Initial Recording of Financial Assets and Liabilities day 1 rules** For items that will be reported at fair value through profit and loss (FVTPL) in future do not include transaction costs. (arrangement fees) For other assets, transaction costs should be added. For other liabilities transaction costs should be deducted (ie; report at the net proceeds.) Eg Smith ltd receives a loan of £80, an arrangement fee of £5 needs to be paid If we will revalue the loan in future If we will not revalue the loan in future --------------------------------------- --------------------------------------------- Dr bank 80 Dr bank 80 Cr bank 5 Cr bank 5 Cr loan liability 80 Cr loan liability 75 (80 -- 5) net proceeds Dr expense 5 **Recording of financial instruments in subsequent years: should we revalue our Fin Inst each year?** If yes use blue route above for arrangement fees, if no use green route above for arrangement fees A capital gain = a rise in value of an item We should revalue a financial instrument if our main aim is to make a capital gain from it. Eg Smith ltd...... Buys some shares in Next plc....... Probably want a capital gain, so do revalue Give a £10m loan to some one....... We do not expect a capital gain, instead we just expect to receive interest and get our £10m back, so do NOT revalue the loan Receive a £30m loan........ our main aim is NOT to make a capital gain, so do NOT revalue the loan............ so 1) arrangement fees will be included in the loan to show net proceeds, 2) we will report amortised cost. **Financial Assets:** [Debt Instrument] These are reported at amortised cost if they meet both the business model test and the cash flow characteristic test, otherwise they are reported at FVTPL. Business model test: The objective of the entity's business model is to hold the financial asset to collect its contractual cash flows ( rather than to sell the instrument prior to its contractual maturity to realise its fair value changes.) Cash flow characteristic tests: The terms of the financial asset solely give rise to receipts of principal and interest on the principal. A fair value option also exists to designate any debt instrument as FVTPL if by doing so it significantly reduces a measurement or recognition inconsistency. Instruments may be moved from one category to another if the business model changes. [Equity Instruments] Held for trading items to be measured at FVTPL. If not held for trading then, either report at FVTPL or irrevocably designate the instrument as an item to be revalued annually with the gain / loss reported in OCI (not allowed to reclassify to PL when sold.) **Financial Liabilities:** Held for trading liabilities are reported at FVTPL, other financial liabilities are reported at amortised cost. A fair value option also exists to designate any debt instrument as FVTPL if by doing so it significantly reduces a measurement or recognition inconsistency or it is part of a group of items which are managed to achieve fair value growth. **What is amortised cost ? = a useful figure if we do not revalue a Fin Inst** This nothing to do with amortisation = wearing out of an intangible asset Amortised cost for financial instruments means two things: - Firstly, report a fair finance cost in the I/S for finance raised. - Secondly, add any unpaid finance costs at a Y/E to the figure reported for the piece of finance in the Y/E Balance Sheet. - Exactly the same principle applies to financial investments but rather than finance costs, we are reporting finance incomes. Eg Smith ltd receives a £10m loan. It is a 4 year loan repaid on last day of year 4. Interest is 0% and a premium of £800,000 is paid at end of year 4 +-------------+-------------+-------------+-------------+-------------+ | Year | Unfair cost | Fair cost | Pay in cash | Y/E | | | | | | Liability | +=============+=============+=============+=============+=============+ | 1 | 0 | £200,000 | £0 | £10.2m | +-------------+-------------+-------------+-------------+-------------+ | 2 | 0 | £200,000 | £0 | £10.4m | +-------------+-------------+-------------+-------------+-------------+ | 3 | 0 | £200,000 | £0 | £10.6m | +-------------+-------------+-------------+-------------+-------------+ | 4 | £800,000 | £200,000 | £800,000 | £0 | +-------------+-------------+-------------+-------------+-------------+ | | | | Cr bank | | | | | | 800,000 | | | | | | | | | | | | Dr expense | | | | | | 200,000 | | | | | | | | | | | | Dr | | | | | | liability | | | | | | 600,000 | | | | | | | | | | | | Cr bank 10m | | | | | | | | | | | | Dr | | | | | | liability | | | | | | 10m | | +-------------+-------------+-------------+-------------+-------------+ A 'fair' cost is called the effective interest rate (you may know this as the Internal Rate of Return) This identifies all the costs related to a piece of finance over its entire life and then spreads these evenly over the life of the finance. Eg; A company issued £1m of 10% loan stock repayable after five years at a premium of £20,000. Issue costs of £10,000 were payable immediately: The effective rate of interest is 10.68%. The annual finance cost and closing balance for the finance is calculated as follows: Year Liability at I/S finance Cash paid Liability at start of year cost 10.68% during the year end of year 1 £990,000 £105,730 £100,000 £995,730 2 £995,730 £106,340 £100,000 £1,002,070 3 £1,002,070 £107,020 £100,000 £1,009,090 4 £1,009,090 £107,770 £100,000 £1,016,860 5 £1,016,860 £108,600 £1,120,000 £nil The above method prevents companies from 'hiding' costs until later years eg: the £20,000 cost above. For Q4 on our Question sheet = Dun plc Remove arrangement fee from loan on day 1 = loan liability = £20m - £0.5m = £19.5m Report a fair cost expense for Y/E 30 Sep 2016 = £19.5 x 10% = £1.95 Liability at end of year should include any unpaid fair finance cost Loan liability at 30 Sep 2016 = £19.5 + (1.95 - £0.5\[interest paid given in question\]) = £19.5 + £1.45 = £20.95 **~~Impairments~~** Non significant balances can be tested on a group basis with allowances created only when indicators of non payment have occurred before the year end.