ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing
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Chapter 11: Financial assets and financial liabilities
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In the statement of financial position or in notes:
Categorisation of financial instruments in the statement of financial position or
in the notes to the financial statements: (these categories are explained later)
Amounts given as security in respect of financial liabilities.
Details of any defaults on loans.
In the statement of comprehensive income, disclosures should include:
Net gains or losses on each category of financial asset or liability
Total interest income and total interest expense (calculated using the effective
interest method) arising from financial instruments that are not ion the category
‘at fair value through profit or loss’
Impairment losses for each class of financial asset.
Disclosure of the risks arising from the use of financial instruments
IFRS7 states that: ‘An entity shall disclose information that enables users of its
financial statements to evaluate the nature and extent of risks arising from financial
instruments to which the entity is exposed at the end of the reporting period.’ The
perceived risks from using financial instruments include credit risk, liquidity risk
and market risk. IFRS7 requires qualitative and quantitative disclosures about these
risks.
Qualitative disclosures include, for each type of risk:
the exposure to risks and how they arise
the entity’s objectives, policies and processes for managing those risks, and
any changes to the above from the previous period.
Quantitative disclosures of risks should be made, according the different types of
risk.
Credit risk is defined as ‘the risk that one party to a financial instrument will cause
a financial loss for the other party by failing to discharge an obligation’. The most
obvious example of credit risk with financial instruments is the risk that a borrower
or a deposit-taking institution (such as a bank) will fail to pay interest or will fail to
repay the principal lent or deposited. Disclosures about credit risk should include:
the maximum exposure to credit risk, without taking into account any assets
held as security
details of any assets held as security
information about the credit quality of the financial assets
an age analysis of financial assets which are ‘past due’ but not impaired
(showing for how long the amounts owed are overdue)
an analysis of financial assets which are ‘impaired’.
Liquidity risk is defined as ‘the risk that an entity will encounter difficulty in
meeting obligations associated with financial liabilities’. In other words it is the risk
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that the entity will be unable to pay what it owes when the payment is due for
settlement. Disclosure is required of:
a maturity analysis for financial liabilities showing the remaining contractual
maturities (showing when the amounts owed are payable)
how the liquidity risk relating to the payment of these liabilities is managed.
Market risk is defined as ‘the risk that the fair value or future cash flows of a
financial instrument will fluctuate because of changes in market prices’. For
example, a company holding shares or bonds in other companies as an investment
is exposed to market risk. Market risk is categorised into currency risk, interest rate
risk and other price risks. The main disclosure requirement in IFRS7 relating to
market risk is the provision of a sensitivity analysis for each category of market risk.
Chapter 11: Financial assets and financial liabilities
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Accounting for the issue of financial instruments
Issue of equity shares
Bonus issue of shares
Accounting for redeemable preference shares: amortised cost
Accounting for fixed rate debt: amortised cost
2 Accounting for the issue of financial instruments
This section explains how to account for the issue of new financial instruments.
2.1 Issue of equity shares
When an entity issues new ordinary shares:
the issued shares become a part of equity, and
the entity receives cash from the issue, or possibly assets other than cash (for
which a carrying value is determined).
The issue price of new equity shares is usually higher than their face value or
nominal value. The difference between the nominal value of the shares and their
issue price is accounted for as share premium, and credited to a share premium
reserve. (This reserve is a part of equity).
Transaction costs of issuing new equity shares for cash should be debited directly to
equity, net of any related tax benefit.
The costs of the issue, net of related tax benefit, are set against the share premium
account. (If there is no share premium on the issue of the new shares, issue costs
should be deducted from retained earnings). The book-keeping entries in the
general ledger are as follows.
When a company issues new shares for cash, the entries would be as follows if there
were no issue costs to account for:
Debit: Bank account, with the actual amount of cash raised
Credit: Share capital, with the nominal value of the shares issued
Credit: Share premium, with the excess of the issue price of the shares over their
nominal value.
However, when shares are issued, there are issue costs. The issue costs are an
allowable expense for tax purposes. The costs of the share issue net of tax benefits
should be set against the share premium (or against retained earnings if there is no
share premium). In addition to the entries listed above, the following gentries are
also required.
Credit: Bank account, with the cash expenditures for the share issue costs
Debit: Share premium with issue costs less tax benefit
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Debit: Tax payable with the tax benefit.
Example
A company issues 200,000 shares of $1 each at a price of $2.50 per share. Issue costs
are $30,000 and the tax benefits associated with these costs will be $10,000.
Required
Show how the share issue should be accounted for:
(a) if there were no issue costs and no associated tax benefits
(b) taking into consideration the share issue costs and associated tax benefits.
Answer
(a) The issue will raise $500,000. Ignoring share issue costs, this would be
accounted for as:
Debit Credit
$ $
Sharecapital:(200,000×$1) 200,000
Sharepremium:(200,000×$1.50) 300,000
Cash 500,000
(b) The issue costs minus associated tax benefits are $20,000 (= £30,000 – $10,000).
Allowing for the share issue costs net of tax benefit, the transaction would be
accounted for as follows:
Debit Credit
$ $
Sharecapital:(200,000×$1) 200,000
Sharepremium:(200,000×$1.50)–$20,000 280,000
Cash($500,000–$30,000) 470,000
Tax(benefit) 10,000
Exercise 1
The summary statement of financial position of Entity GH just prior to a new share
issue is as follows.
$ $
Assets
Non‐currentassets
2,000,000
Currentassets
Inventories 56,000
Receivables 102,000
–
–––––––
158,000
–
–––––––
–
Totalassets 2,158,000
–
–––––––
–
Chapter 11: Financial assets and financial liabilities
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Equityandliabilities
Equity
1,000,000ordinarysharesof$0.50 500,000
Sharepremium 240,000
Retainedearnings 1,068,000
–
––––––––
1,808,000
Currentliabilities
Tradepayables 250,000
Bankoverdraft 100,000
–
––––––––
350,000
–
––––––––
Totalequityandliabilities 2,158,000
–
––––––––
Entity GH makes an issue of 250,000 new ordinary shares for cash, at $3 per share.
Share issue costs are $40,000 and the related tax benefit is $15,000.
Required
Prepare a summary statement of financial position for the company after the share
issue.
2.2 Bonus issue of shares
A bonus issue of shares is the issue of new shares by an entity to its existing
shareholders, at no cost to the shareholders and on a pro rata basis. For example, in
a 1 for 4 bonus issue, existing shareholders would receive one new share in the
company for every four shares they currently hold. The entity does not raise any
cash. In a bonus issue, the company issues the shares by converting some reserves
into share capital. The reserves converted into share capital might be share premium
or retained earnings.
If the entity has a sufficiently large share premium account, the nominal value of the
new shares is deducted from share premium.
Credit: Share capital (nominal value of new shares issued)
Debit: Share premium
If the nominal value of the new shares issued exceeds the balance on the share
premium account, the excess amount should be deducted from retained earnings.
Example
Entity FG has 24 million ordinary shares of $0.50 each in issue. The balance on the
share premium account is $14 million. The entity makes a 1 for 3 bonus issue.
Required
Show the accounting treatment of this bonus issue.
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Answer
8 million new shares will be issued (24 million × 1/3).
The issued share capital will increase by $4 million (8 million shares × $0.50
nominal value per share), from $12 million to $16 million (32 million × $0.50).
The share premium will be reduced by $4 million to $10 million.
Beforethebonusissue Afterthebonusissue
$million $million
Sharecapital 12 16
Sharepremium 14 10
––
–
–
––
–
–
26 26
–
–
–
–
––
–
–
2.3 Accounting for redeemable preference shares: amortised cost
When an entity issues redeemable preference shares, it is under an obligation to buy
back the shares at a future date. This obligation to redeem the shares is a financial
liability.
Accounting for the issue and redemption of redeemable shares, under IAS32 and
IAS39, is based on the following principles.
An entity might issue redeemable shares at a premium to their nominal value
(par value).
The shares will eventually be redeemed either at their nominal value (par value)
or at a premium to par value.
For the period between the issue of the shares and their redemption, there is a
finance cost to the entity. This finance cost consists of two elements:
− the dividends paid throughout the ‘life’ of the shares, between issue and
redemption, and
− the difference between the eventual cost of redemption and the amount
raised from the original share issue. This difference is an addition to cost if
the redemption cost exceeds the amount of the original issue. It is a negative
cost if the amount payable at redemption is less than the amount of the
original share issue.
The full finance cost or finance charge over the life of the financial instrument
should be allocated to each year over the life of the shares so as to give a constant
effective annual rate of interest.
When a financial liability is recognised initially, it should be measured at its fair
value minus the issue costs. For example, if redeemable preference shares are
regarded as a financial liability, and the shares are issued for $1,000,000 with $60,000
issue costs, the liability should be recorded initially as $940,000 (= $1,000,000 –
$60,000).
Chapter 11: Financial assets and financial liabilities
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In each subsequent year, the value of the financial liability in the statement of
financial position at the end of the year is measured at amortised cost. Amortised
cost is:
the value of the liability at the beginning of the year,
plus the interest cost on this value, calculated at the (constant) effective annual
rate of interest,
minus any amounts of the liability paid during the course of the year. In the case
of redeemable preference shares as a financial liability, amounts paid are:
– dividends and
– the payment of the redemption value of the shares at their redemption date.
The interest cost each year is an expense, within profit or loss for the year.
These principles might seem confusing. An example should help to explain them
more clearly.
Example
A company issues 2 million redeemable preference shares of $1 each that will be
redeemed after five years. The holders of the preference shares are entitled to an
annual dividend of 5%. The issue price was at par and issue costs were $100,000.
The shares will be redeemed at par after five years, and redemption costs will be
$34,000.
It has been calculated that the effective annual interest rate for this financial liability
is 6.5% per annum.
Required
Outline the treatment of the shares over the 5-year period.
Answer
The redeemable preference shares are a financial liability, within the definition
guidelines of IAS32. When the shares are issued, the original liability in the
statement of financial position is $1,900,000 ($2,000,000 less issue costs of $100,000).
When the shares are redeemed, the company will pay $2,000,000 + $34,000 =
$2,034,000.
The cost of redeeming the shares is therefore greater than the initial liability by
$134,000. Annual preference dividends are $100,000 (= $2 million × 5%). The total
finance charge over the life of the shares, including the dividend payments, is
therefore:
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$
Excessoftheredemptioncostovertheinitialliability 134,000
Dividendspayableoverthelifeoftheliability(5years×$100,000) 500,000
–
–––––––
Totalfinancecharge 634,000
–
–––––––
This total finance charge is allocated to each of the five years in order to give a
constant annual rate of interest on the outstanding liability. The liability changes
each year. In this example, the effective annual interest rate is 6.5%.
The preference shares are therefore accounted for as follows:
Liabilityat
beginning
ofyear
Finance
chargeat
6.5%
Dividend
paid
Capital
repayment
andcosts
Outstanding
liabilityatend
ofyear
$ $ $ $ $
Year1 1,900,000 123,500 (100,000) 1,923,500
Year2 1,923,500 125,028 (100,000) 1,948,528
Year3 1,948,528 126,654 (100,000) 1,975,182
Year4 1,975,182 128,387 (100,000) 2,003,569
Year5 2,003,569 130,232 (100,000) (2,034,000) (199)
–
–––––
–
633,801
–
–––––
–
Here, there is a rounding error of $199 in the figures.
The total finance charges over the five years are $633,801. Allowing for the rounding
error, this is the $634,000 calculated earlier. The total finance charge has been
allocated between the five years.
In the financial statements of the company:
The outstanding liability in the statement of financial position each year is the
figure in the right hand column of the table above. This is the amortised cost of
the financial instrument. Ignoring the rounding error, this will be $0 after five
years.
The liability can be divided into a current liability (amount repayable within 12
months) and a long-term liability. This amount repayable each year is calculated
by taking the difference between the outstanding liability at the end of the
current year and the end of the next year.
The finance charge each year (interest cost) is the amount in the finance charge
column. This is a charge against profit.
Debit: Income statement
Credit: Financial liability (= addition to the liability).
The cash dividend payment each year is accounted for as follows:
− Credit: Bank $100,000
− Debit: Financial liability (= a reduction in the liability in the year).
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2.4 Accounting for fixed rate debt: amortised cost
Straight fixed interest rate debt instruments are accounted for in the same way, as
financial liabilities.
The initial liability is the issue price of the debt instrument minus any issue
costs.
The redemption cost of the debt instrument is its redemption price plus any
redemption costs.
The total finance charge over the life of the instrument is the interest payable,
plus or minus the difference between the initial liability and the redemption cost.
This difference is subtracted from the finance charge if the initial cost is higher
than the redemption cost, and added if the initial cost is lower than the
redemption cost.
A finance charge is calculated each year, based on an effective annual interest
rate for the full term of the instrument.
The outstanding liability at the end of each year is calculated as:
$
Outstanding liability at the beginning of the year A
Plus: Finance charge B
–
–––
–
–
A + B
Minus: Interest paid (C)
–
––––––––
Equals: Outstanding liability at the end of the year A + B – C
–
––––––––
Example
A company issues $10 million of 6% bonds at a price of 100.50 and issue costs are
$50,000. The bonds are redeemable after four years at a price of 104.00 and
redemption costs will be $44,000. (Note: A price of 104.00 means that the price is
$104 for each $100 nominal value of bonds.)
It has been calculated that the effective annual interest rate for this financial
instrument is 7%.
Required
Show how the bonds should be accounted for in each of the four years.
Answer
The income from issuing the bonds is the money raised minus the issue costs.
The initial liability is therefore ($10 million × 100.50/100) – $50,000 = $10,000,000.
When the bonds are redeemed, the company will pay the redemption price of 104
plus the redemption costs of $44,000. The total redemption cost of the bonds is ($10
million × 104/100) + $44,000 = $10,444,000.
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The cost of redeeming the bonds is therefore more than the initial liability, by
$444,000. The total finance charge over the life of the bonds is therefore:
$
Differencebetweenredemptioncostandinitialliability 444,000
Interestpaid($10million×6%×4years) 2,400,000
–
–––––
–
–
–
Totalfinancecharge 2,844,000
–
–––––––
–
This total finance charge is allocated to each of the four years in order to give a
constant annual rate of interest on the outstanding liability. The liability changes
each year. In this example, the effective annual interest rate is 7%.
The preference shares are therefore accounted for as follows:
Liabilityat
beginning
ofyear
Finance
charge
at7%
Interest
paid
Capital
repayment
andcosts
Outstanding
liabilityat
endofyear
$ $ $ $ $
Year1 10,000,000 700,000 (600,000) 10,100,000
Year2 10,100,000 707,000 (600,000) 10,207,000
Year3 10,207,000 714,490 (600,000) 10,321,490
Year4 10,321,490 722,504 (600,000) (10,444,000) (6)
–
–––––––
–
2,843,994
–
–––––––
–
The outstanding liability at the end of each year is the figure in the right hand
column of the table. This is the amortised cost of the debt.
The finance charge for each year is shown in the finance charge column.
Here there is a rounding error of $6 in the figures. The total finance charge over the
four years is shown as $2,843,994 in the table, instead of $2,844,000. Allowing for the
rounding error, this is the $2,844,000 calculated earlier, but the charge total has been
allocated between the four years.
Ignoring the rounding error, the outstanding liability at the end of Year 4 should be
$0.
2.5 Accounting for convertible bonds
When convertible bonds are issued they are shown in the statement of financial
position partly as debt finance and partly as equity finance. The question is how to
determine the amount of the issue price that is debt and the amount that is equity.