Notes on Financial Instruments Lecture

Introduction

• Presenter: Tom Clendon, ACCA SBR subject specialist and online tutor
• Focus: Understanding financial instruments, specifically financial assets.
• This lecture serves as both tuition and last-minute revision.
• Recommended to have pen and paper for working through examples and concepts.

Importance of Financial Instruments

• Financial instruments are a major exam topic in SBR.
• Can be tested in various formats (written or numerical).
• Every question in SBR is compulsory, thus understanding is crucial.

Definitions

• Financial Instrument: A contract creating a financial asset in one entity (e.g., trade receivables, loans) and a financial liability or equity instrument in another.
• Examples of Financial Assets:
  • Trade Receivables
  • Loans (as assets for the lender)
  • Equity Shares
  • Investments in Bonds or Debentures

Life Cycle of a Financial Asset

1. Classification: Identify the type of financial asset.
   • Determines the initial measurement method.
2. Initial Measurement: How the asset is recorded initially (cost vs. fair value).
3. Subsequent Accounting: How the asset is accounted for in future periods (amortized cost or fair value).
4. De-recognition: Removing the financial asset from accounts when it no longer exists in substance.

Categories of Financial Assets

• Three Categories:
  1. Amortized Cost
  2. Fair Value through Other Comprehensive Income (OCI)
  3. Fair Value through Profit and Loss (P&L)

Cash Flow Test (SPPI)

• Examines if cash flows are solely payments of principal and interest.
• If yes, it is classified as a debt instrument; if no, it is classified as an equity investment.

Business Model Considerations

• If the intention is to hold the asset to maturity, classify as amortized cost.
• If there is potential to sell the asset, use fair value classification (either through OCI or P&L).

Accounting for Financial Assets

• Debt Instruments: If SPPI is passed, consider the business model for classification.
• Equity Instruments: Always classified at fair value, defaulting to fair value through P&L unless an irrevocable election is made for OCI.

Examples and Application

• Example concerning Clendon’s financial instruments:
  • Investment Amount: 100 million
  • Return: 10% regular return, received 10 million this year.
  • Fair Value at Reporting Date: 125 million.
• Discussion Points: How to classify and account for this investment based on cash flow test and business model.

Financial Instruments in Practice

• In exams, you may need to adjust entries based on classification differences (fair value through P&L vs OCI).
• Understanding impacts on group profit and loss accounts.
• Statement of Financial Position: Adjustments based on treatment (P&L vs OCI).

Initial Measurement Rules

• Amortized Cost: Fair value + Transaction Costs (TC).
• Fair Value through OCI: Similar treatment as amortized cost concerning transaction costs.
• Fair Value through P&L: Transaction costs written off immediately.

Subsequent Measurement

• Amortized Cost: Accounted at amortized cost.
• Fair Value through P&L: Remeasured at each reporting date with gains/losses through P&L.
• Fair Value through OCI: Remeasured at fair value with gains/losses through OCI.

Derecognition and Impairment

• Derecognition occurs when risks and rewards of ownership are transferred.
• Impairment and expected credit losses are significant areas for further study.

Resources for Further Study

• Study Hub: Access chapter 8 on financial instruments for detailed explanations and resources.
• Podcasts and Practice Platforms: Available on Spotify, Apple, and ACCA platforms.
• Emphasis on practicing with exam questions to understand application.

Conclusion

• Understanding the classification process informs subsequent measurement.
• Practicing with questions is crucial for exam readiness.