Financial Instruments

ASPE: 3856

Financial Instruments ASPE: 3856

Definitions

  • A financial Instrument is a contract that creates a financial asset for one entity and a financial liability or equity instrument of another entity.
  • Financial Asset
    • cash
    • an equity instrument of another entity;
    • a contractual right to receive cash or another financial asset from another entity; or
    • a contractual right to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity
  • Financial Liability
    • a contractual obligation to deliver cash or another financial asset to another entity; or
    • a contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or

Measurement of Financial Instruments:

Initial measurementat the amount you paid for it (i.e. cost)

Subsequent measurement:

I.   Investments in Equity Instruments

•  If quoted in an active market (i.e. publically trades shares) – measure @ FV
•  If not quoted in an active market – measure @ cost

II.   Other Financial Assets

•  Amortized cost

III.  Financial Liabilities

•  Amortized cost

IV.  Under ASPE you have the option to designate any financial instrument to be measured @ fair value

•  3856:13 says- An entity may elect to measure any financial asset or financial liability at fair value by designating that fair value measurement shall apply

V.  If active market disappears you have 2 options: designate FV or use cost onwards

Transaction costs
  • Transaction costs = costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability (i.e. legal fees, commission, transfer taxes)
  • Only capitalize transaction costs and fees on investment purchases if they’re not going to be revalued to FV @ the end of the period (i.e. active market does not exist or not designated to be held at FV)
  • In other words, If you’re buying an investment that’s carried at cost then capitalize transactions costs
Impairment of financial assets
  • For financial assets that are recorded at cost, you need to assess at the end of every fiscal year if there are indications of impairment
  • If there are indications of impairment write down the financial asset to the highest of:
    • Higher of:
      1. PV future expected CF (using current MKT rate) by holding the asset
      2. Selling Price
      3. Amount realizable from collateral net of costs
        • This makes sense because the lender would want to choose the higher option
  • What if the value of these financial assets subsequently increases? You are allowed to write up to the extent of previous losses taken

Presentation of a Financial Instrument

  • The issuer either records financial instruments as liabilities or equity
  • The key takeaway here is substance over form – just because someone issues preferred shares; in legal form it may be shares; but in substance it may be a liability (so please consider the definition of financial assets/liabilities before making the classification)
Compound Financial Instrument
  • A compound financial instrument has both equity and liability components
  • Example: ABC Bank issues to me a convertible debt; the bank has the option to convert this debt into a fixed number of shares (say 100 shares).
    • This particular instrument has both a debt component – i.e. the loan
    • It also has an equity component because the bank has the option to convert to a fixed number of shares
    • One other thing to take away is that because this is a convertible debt, it is less risky for the lender and therefore it has a lower interest rate
  • 2 Options to measure compound financial instruments under ASPE
    • Allowed to make equity = 0 and liability = entire amount of proceeds; OR
    • Measure the easier to measure of the liability or equity (this is usually the PV of the liability using interest rate without the conversion option) and allocate the remainder of the proceeds to the other component (usually equity)
Mandatory Redemption/ Retractable Shares
  • This is when either you must redeem your shares or the holder of the shares has the right to force you to redeem
    • Substance over form kicks in; it is a financial liability because it is a contractual obligation to deliver cash
    • Once these “shares” are presented as a financial liability any dividends you pay are actually interest and shown as interest expense (rather than a dividend through R/E)
  • If shares have mandatory redemption/retractable feature and they are like common shares (i.e. the most subordinate) then it is treated as equity. These shares must have all the following properties to be classified as equity:
    • The most subordinate of all shares ( like common shares)
    • Available to 100% of common shareholders
    • The shares get a pro rata share of the residual equity
    • No preferred rights to other share classes
    • Redemption event same for all classes
  • The reasoning behind this is that there needs to be at least one common share (i.e. the most subordinate class of shares) issued for a company
Preferred shares issued under tax planning arrangements (i.e. 51, 85, 85.1, 86, 87 or 88)
  • MUST classify this as equity (in a separate line item)
  • When shares are redeemed reclassify it to liability with any gain or loss put through Retained Earnings

Dr. P/Shares issued in tax planning arrangement              $100
Dr. Retained Earnings                                                                   50
                    Cr. Liability to investor                                                            $150

Perpetual Debt
  • These are debt instruments where the principal is never due; you just continue to pay interest
  • Is this a financial liability or equity?
    • This is a financial liability because a contractual obligation to deliver cash (interest)
    • The PV of the future interest cash flows is shown on the balance sheet as a financial liability accounted for using amortized cost method!

Spread the Word!

Share on facebook
Facebook
Share on google
Google+
Share on twitter
Twitter
Share on linkedin
LinkedIn
Share on reddit
Reddit
Share on email
Email
Share on whatsapp
WhatsApp
Scroll to Top