Financial Assets and Liabilities

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FINANCIAL ASSETS AND LIABILITIES

14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 1

IntroductionLearning outcomesExplain what financial instruments are Define financial instruments in terms of

financial assets and financial liabilitiesDistinguish between the categories of

financial instrumentsDistinguish between debt and equity

capitalAccount for compound instruments 214/08/2014

FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39)

Introduction Learning outcomes Account for issue of equity shares & payment

of equity dividends Account for the issue of redeemable

preference shares and payment of preferenceshare dividends

Understand the recognition, Presentation anddisclosure of financial instruments


Accounting standards IAS 32 Financial instruments: presentation IAS 39 Financial instruments: recognition

and measurement IFRS 7 Financial instruments: disclosures IFRS 9 Financial instrumentsNote :IFRS 9 was issued in 2009 and is

effective January 2015 but earlier adoptionis permitted will eventually replace IAS 39&32


Definition of Financial instrumentA financial instrument is any

contract that gives rise to afinancial asset of one entity and afinancial liability or equity onanother entity e.g.

Bonds ,stocks and derivativeinstruments


Definition of financial asset A financial asset is any asset that has: A contractual right to receive cash or another

financial asset from another entity A contractual right to exchange financial

assets/liabilities with another entity underconditions that are potentially favorable

An equity instrument of another entityE.G Trade receivables(note), Options,

Investment in equity shares. Investment inBond, or loans


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Definition of financial liability A financial liability is any liability that is a

contractual obligation: To deliver cash or another financial asset to another

entity, or To exchange financial instruments with another

entity under conditions that are potentially unfavorable, or

That will or may be settled in the entity’s own equityinstruments.

E.g. trade payables, Bonds, Debenture loans,Redeemable preference shares


Definition of financial liability/asset

A 'contract' need not be in writing, but itmust comprise an agreement that has 'cleareconomic consequences' and which theparties to it cannot avoid, usually becausethe agreement is enforceable in law.

There should be a contractual obligationto receive cash or another financialinstrument


ExamplesWhen a company borrow a loan or sells

a Bond that's a financial liabilityWhen a company lends out a loan or

buys a Bond that's a financial asset


Question to think aboutWhich of the following are financial

Assets /liabilities1. inventories, 2. property, plant and equipment3. Investment in ordinary shares4. Prepayment for goods or service5. Income tax liability


Solution1. Inventory :no present or contractual right

to receive cash2. property, plant and equipment; Control

of physical assets creates an opportunity to generate an inflow of cash or other assets, but it does not give rise to a present right to receive cash or other financial asset


Solution3.Investment in ordinary shares; Yes there

is contractual obligation and it is an instrument of another entity.

4. Prepayment for goods or service. No future economic benefit is goods or service not a financial asset

5. Income tax liability. No it is a statutory not contractual obligation.


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Classification of financial instruments

Classified in to 21. Asset /liability instruments2. Equity instruments


Classification of financial instruments(asset/liability)

A financial liability has a contractual obligation:to deliver cash or another financial asset to another

entity, or to exchange financial instruments withanother entity under conditions that are potentially unfavorable, or

A financial asset has a contractual right toreceive cash or another financial asset from anotherentity, or to exchange financial instruments withanother entity under conditions that are potentiallyfavorable

Eg Bonds ,loans ,redeemable preference shares


Classification of financial instruments(equity)

An equity financial instrument does not give rise to a contractual obligation/ right

Although the holder of an equity instrument may be entitled to receive dividends , the holder cannot under law force the issuer to declare dividends, so the issuer does not have a contractual obligation to make such distributions

E.g. common stoke and preference shares Note: redeemable preference shares are classified as a

liability because the issuer has a contractual obligation to deliver cash to the order on the redemption date.(if the company bought then its in asset


Recognition of financial instruments

An entity recognize a financial asset or a financial liability in the statement of financial Position when, and only when, it becomes a party to the contractual provisions of the instrument.


Derecognition of financial asset/liability

Asset when, and only when, thecontractual rights to the cash flows of thefinancial asset have expired

Liability when, and only when, theobligation specified in the contract isdischarged, cancelled or expires


Measurement of financial instrument

How the instrument is measured depends on its classificationa liability /asset or equity

We will start with Liabilities then assets and conclude with a equity


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Measurement of financial Liability all financial Liabilities are initially

measured at fair value. This is likely to be the purchase consideration received for the financial liability less issue costs

Fair value =Cost –discount –issue costsTransaction costs/gains are expensed to the

income statement


Subsequent measurement of financial liability

Liabilities incurred for speculative purposesare measured at fair value any gains/losses are taken to the income statement

All other liabilities are measured atamortised cost using the effectiveinterest rate method

Examples of liabilities include, loanspayable and deep discount bonds


Amortised cost methodMethod used to calculate how much should

be charge to income statement and in thestatement of Financial position

Amortised cost=Initial cost + interest-repayments

Interest is charged at the effective rateNote: Financial management principles

needed to apply this method


Reminders BAC 331 features of debt

Par value or nominal value=the principleamount or the face value of the bond/loan

Effective interest rate=the periodicinterest rate charged for the debt

Coupon payment =periodic paymentmade toward the interest

At maturity =par value should be paidtogether with the interest outstanding



Debt can be at discount ,par or premiumDiscount means fair value amount received

is less than face valuePar means amount received is equal to face

valuePremium means amount received is greater

than face value



ExampleA K2, 500 8 % bond debt is redeemable at

K3, 125. The debt will mature after 5 years. The effective rate of interest is 10%

What is the annual rate of interest to be charged

What is the annual rate of interest to be paid


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Solution annual rate of interest to be charged is 10%

of the Of outstanding amount (not fixed) annual rate of interest to be paid is 8% of

par value (fixed) 2,500 X 0.08 =200


Amortised cost methodMethod used to calculate how much should be

charge to income statement and in the statementof Financial position

Amortised cost=Initial cost + interest-repayments


ExampleA company issues 4% loan notes with a nominal

value of K100, 000. The loan notes are issued at a discount of 2.5% and K2, 670 of issue costs are incurred. The loan notes will be repayable at a premium of 10% after 5 years. The effective rate of interest is 7%.

a)What amount will be recorded as a financial liability when the loan notes are issue

b)What amounts will be shown in the income statement and statement of financial position for years 1 – 5?

c) Show the journal entries for (a)and (b)


Solution

a)Liability initially recorded at fair valueFair Value =Cost –discount-issue costCost =100,000Discount=2,500(100,000 x 0.025)Issue cost K2,670 Fair Value =100,000-2,500-2670

K 94,830


Solution B)Amount to be shown in income statementYear Opening Finance Cash paid 4% Closing

costs 7%

1 94,830 6,638 (4,000) 97,4682 97,468 6,822 (4,000) 100,2903 100,290 7,020 (4,000) 103,3104 103,310 7,232 (4,000) 106,542

5 106,542 7,457 (4,000)(110,000) 0

Note the balance at year 5 would have been (110,00) which is repaid as principle

If interest is paid at the beginning subtract from the opening balance then calculate the finance charge


Solution Finance cost are charged to the income statement The closing balance is the liability in the statement of

financial positionYear Finance cost(i/s) Non-current

liabilities(SFP)1 6,638 97,468

2 6,822 100,2903 7,020 103,3104 7,232 106,5425 7,457 0


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Solution Journal entries a)when loan is issued

Dr Crcashbook 94,830

N.C.Liability 94,830

During the years(1-5)Finance Charge as calculatedN.C.Liability as calculated

Payments(year 1-5)N.C.Liability 4,000Cash book 4,000loan Repayment year 5N.C.Liability 110,000Cash book 110,000


Example 2A company issues 0% loan notes at theirnominal value of K20, 000. The loan notes arerepayable at a premium of K5, 900 after 3 years.The effectiverate of interest is 9%.a)What amount will be recorded as afinancial liability when the loan notes areissued?

b)What amounts will be shown in thestatement of profit or loss and statement offinancial position 1 -3-?

c)Show the journals for (a) and (b)14/08/2014

FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 32

Solutiona)Liability initially recorded at fair valueFair Value =Cost –discount-issue costCost =20,000Discount=0Issue cost =00 Fair Value =K20,000


solution B)Amount to be shown in income statement

Year Opening Finance Cash paid 0% Closingcosts 9%

1 20,000 1,800 (0) 21,800

2 21,800 1,962 (0) 23,762

3 23,762 2,138 (0)(25,900) 0

The loan notes are repaid at par i.e. K20, 000, plus a premium of K5, 900 at the end of yea 3.


Solution When the loan notes are issue:

Dr cash book K20,000Cr Loan notes K20,000

During the years(1-3)Finance Charge as calculatedN.C.Liability as calculated

loan Repayment year 3N.C.Liability 25,900Cash book 25,9000


Preference shares Redeemable preference shares are classified as

a liability because the issuer has a contractualobligation to deliver cash to the order on theredemption date.(if the company bought thenits in asset

Irredeemable preference shares are classified asequity

Redeemable shares are initially measure at fairvalue and subsequent at amortised cost if notheld for resale


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example On 1 April 2007, a company issued 80,000 K1

redeemable preference shares with a coupon rate of 8% at par. They are redeemable at a large premium which gives them an effective finance and cost of 12% per annum.

How would these redeemable preference shares appear in the financial statements for the years ending 31 March 2008 and 2009?

Show the journal entries


Solution Annual payment =80,000 x K1 x 8% = K6,400 Period Opening Finance Cash Closing

ended balance cost paid balance

31 March @ 12% @8%

2008 80,000 9,600 (6,400) 83,200

2009 83,200 9,984 (6,400) 86,784

i/s SFP


Solution Journals1. When stock is issued

Dr cash book K80,000Cr Ncliability K80,000

2. Finance charge during the periodDr interest expense amount calculated

Cr Ncliability amount calculated3Cash payment

Dr Ncliability 6400 (per year)Cr Cash book 6400


Measurement of Financial assets all financial assets are initially measured at

fair value. This is likely to be the purchase consideration paid to acquire the financial asset

Transaction costs are expensed to the income statement


Subsequent measurement of financial assets

Subsequent measurement depends uponwhether the financial asset is an investmentheld for Speculative(sale) or to hold it tillmaturity


Subsequent measurement of financial assets

Assets can be measured using either of the following methods.

1. Fair value method-based on the consideration received or given( any gain /losses are taken to income statement)

2. Amortised


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Amortised cost methodThe amortised cost = initial cost + interest-

repayments. The interest will be charged at the effective rate. This

is the internal rate of return of the instrument

Amortised cost is only used if the 2 test are met

1.The business model test 2.Contractual cash flow characteristics test


The business model test This test establishes whether the entity holds

the financial asset to collect the contractual cash flows or sell the financial asset prior to maturity to realize changes in fair value.

If its to collect the cash flows then the asset has passed this test and the amortized cost method can be used

IF its for sell the fair value should be used


The contractual cash flow characteristics test

This test determines whether the contractualterms of the financial asset give rise to cashflows on specified dates that are solely ofprincipal and interest based upon theprincipleamount outstanding.

.If this is not the case, the test is failed and thefinancial asset cannot be measured atamortised cost but at fair value.

EG convertible bonds have a right to convert thebond to equity so don’t qualify


Example A company invests K5, 000 in 10% loan notes. The loan

notes are repayable at a premium after 3 years. The effective rate of interest is 12%. The company intends to collect the contractual cash flows which consist solely of repayments of interest and capital and have therefore chosen to record the financial asset at amortised cost.

What amounts will be shown in the income statement and statement of financial position for the financial asset for years 1 -3?



SolutionYear Opening Investment Cash Closing

Income 12% received 10%1 5,000 600 (500) 5,1002 5,100 612 (500) 5,212 3 5,212 625 (500)

(5,337) 0


SolutionJournals

1. When loan is givenDr asset (investment) K5,000

Cr Cash book K5,000

2. Investment income during the periodDr Asset(investment ) amount calculated

Cr investment income amount calculated3Cash payment

Dr Cash book 5,000 (per year)Cr Asset(investment ) 5,000

4 Final receipt repaymentDr cash book 5,337Cr Asset(investment ) 5,337


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Measurement of Equity instrument

The equity instruments are measured depends on whether they are held for trading or as an investment (not for trading)


Measurement of Equity instrument held for trading

Measured at Fair value through Income statement

This means that equity instrument is always recorded at market value in the statement of financial position

The difference between original price and the market price is taken to the income statement under investment income


Measurement of Equity instrument not held for trading

Measured at Fair value through other comprehensive income

Other comprehensive income is income and expenses that are not recognized in the income statement but are recorded in reserves

This means that equity instrument is always recorded at market value in the statement of financial position

The difference between original price and the market price is taken to the reserves in the statement of comprehensive income


Example (2) A company invested in 10,000 shares of a listed

company in November 2007 at a cost of K4. 20 per share. At 31 December 2007 the shares a market value of K4.90. The company is planning on selling these shares in April 2008.Prepare extracts from the statement of profit or loss for the year ended 31 December 2007 and a statement of financial position as at that date.



solutionThis an investment held for trading purposes as the

company plans to sell these shares. The investment should therefore be measured at fair value through income statement.

Statement of profit or lossInvestment Income (10,000 x (4.90 – 4.20)) 7,000

Statement of Financial PositionCurrent assetsInvestments (10,000 x 4.90) 49,000


Solution JournalsInitial investmentDr investment in equity K42,000 (4.2 x 10,000)Cr cash book K42,000Change in market valueDr investment in equity 700((4.9-4.2)x10,000)Cr investment income 700Note if the price has gone down the asset is cr and

investment expense Dr


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Example 2 A company invested in 20,000 shares of a listed

company in October 2007 at a cost of K3.80 per share. At 31 December 2007 the shares have a market value of K3.40. The company is not planning on selling these shares in the short term.Prepare extracts from the statement of profit or loss for the year ended 31 December 2007 and a statement of financial position as at that date



Solution The investment is a financial asset at fair value

through through other comprehensive income. Statement of profit or loss Revaluation reserves (20,000 x (3.40 – 3.80)) (8,000)

Statement of Financial PositionNon-current assetsInvestments (20,000 x 3.40) 68.000


Solution JournalsInitial investmentDr investment in equity K76,000 (3.8 x 20,000)Cr cash book K76,000Change in market valueCr investment in equity 8000((3.4-3.8)x20,000)Dr Revaluation reserves 8000Note if the price has gone up the asset is Dr and

Reserves Cr


Offsetting financial assets/financial liabilities

Off setting not allowed except when the entity

Has a legally enforceable right to set off the amounts, and

Intends either to settle on a net basis or to realize the asset and settle the liability simultaneously


Compound instruments This is a financial instrument that has

characteristics of both equity and liability .E.g. debt that can be converted into shares like convertible bonds


Compound instruments IAS 32 required compound financial

instruments be split into their componentparts:

A financial liability (the debt)An equity instrument (the option to convert

into shares).These must be shown separately in the

financial statements.14/08/2014


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Compound instruments how to split and record

Step 1Calculate liability component first by finding the value of

the bond( present value of future cash flows assuming non-conversion)Apply discount rate equivalent to interest on similar non-convertible debt instrument (i.e. discount the cash flows at the market rate of interest)

Step 2Calculate the equity component by

deducting the present value of the debt from the proceeds of the issue


Compound instruments how to split and record

Step 3 Basing on the amortized cost method ,and using

the amount of liability found as the openingbalance calculate amounts to be recorded inincome statement and statement of financialposition

Step 4Calculate the conversion amount basing on

information givenNote use financial management principles on

calculating present value(time value of money )14/08/2014


Reminders BAC 331 present valuePresent Value is the current value of the

future sum discounted back to the present at an appropriate interest rate.The process of finding the present

value is called discounting


Reminders BAC 331 present valuePV= FV or PV = FV = ( 1+r)- n

(1+r) n

discount factor

PV is the present value to be calculated FV is the future value given r is the interest rate n is the number of periods interest is earned


Reminders BAC 331 present valueExampleBarclays bank issues 2500o 5% loan that

attracts interest rate of 10 % and is repayable in full after three years.

What is the present value of the loan?


Reminders BAC 331 present value Solution

( 1+r)- n Fv X discount factor

Year Cash Discount factor Present valueflow

1 1,250 ( 1+0.1)- 1 =0.909 1,250X0.909=1,136

2 1,250 ( 1+0.1)- 2 =0.826 1,250X0.826=1,033

3 1,250 ( 1+0.1)- 3 =0.751 1,250X0.751=939 3 25000 (1+0.1)-3 0.7513 25000X0.751=18,775

PV=1,136+1033+939+18,782=21,890


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Reminders BAC 331 present value alternative

PV = a 1- (1+r)-n + Par(1+r)-n

r

PVA is present value of an annuity to be calculateda is the installment payment/receiptr is the interest raten is number of periods interest is given

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Reminders BAC 331 present value

PV = 1,250 1- (1.1)-3 +25000(1+0.1)-3

0.1 3,108.56+18,782.87 21,891.43

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Example compound instrumentA company issues 2% convertible bonds at their nominal

value of K36, 000.

The bonds are convertible at any time up to maturity into 120 ordinary shares for each K100 of bond. Alternatively the bonds will be redeemed at par after 3 years.

Similar non-convertible bonds would carry an interest rate of 9%.


Example compound instrumentThe present value of K1 payable at the end of year, based on rates of

2% and 9% are as follows:

End of year 2% 9%1 0.98 0.922 0.96 0.843 0.94 0.77

What amounts will be shown as a financial liability and as equity when the convertible bonds are issued?

What amounts will be shown in the income statement and statement of financial position for years 1 – 3?


SolutionStep 1 Calculate liability componentCash flow = 2% x 36,000 = 720 YearCash f low Discount factor 9%Present value 1 720 0.92 662.4 2 720 0.84 604.8 3 720 0.77 554 .4

3 36,000 0.77 27,72029,541.6


solution Calculate the equity componentproceeds of the issue-liability component

36,000- 29,541.6=6,458

Journal entryWhen the convertible bonds are issued:

Dr Bank K36, 000Cr Financial Liability K29,542Cr Equity K6,458


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Solution Step 3 measurement of liability amortized costYear Opening Finance Cash paid 2% Closing

costs 9%1 29,542 2,65 (720) 31,4812 31,481 2,853 (720) 33,5943 33,594 3,023 (720)

(36,000) 0I/S SFP


Solution Step 4 Calculate the conversion of bondCaring amount as at end of year 3Equity 6,458Bond 36,000

42,458120 ordinary shares for each K100 of bond.

X shares for 36,000 bond( 120X 36,000) /100

=43,200The difference between the Caring amount and the

conversion amount is recorded as either discount or premium 42,458-43,200=742 discount


Interest dividends ,loses and gains The accounting treatment of interest and

dividends depends upon the accounting treatment of the underlying instrument itself. E.g.

Equity dividends declared are reported directly in equity

Dividends on redeemable preference shares classified as a liability are an expense in the income statement .


Disclosure Disclosure must be made for each type of financial

instrument (Liability ,asset or equity) gains expenses and losses should be shown

appropriately


Any questions


Financial Assets and Liabilities

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