Overview of Financial Instruments and Their Importance

My name is Tom Clendon and I am an ACCA SBR subject specialist and an online tutor and I'm here to help you get a better understanding of the tricky topic relating to financial instruments, specifically financial assets. Now This video sits somewhere between tuition and, you know, last minute revision. So you're going to get the most out of this if you're already familiar a little bit with financial assets and certainly the term amortised cost. I want you to have a pen and paper to hand and be prepared to pause the video at certain times so that you can work out... some of the questions, you can get ahead of me in terms of my explanation. You're probably going to benefit from watching this video more than once. I hope you enjoy the show. Financial instruments seems to be always examined. It's a massive topic and it can come up in words or numbers. So it's important that you understand the principles so you can explain them. And it can appear anywhere in the exam. Remember, every question in SBR is compulsory. So if it comes up, you've got to be able to deal with it. Now, for the avoidance of any doubt, a financial instrument is a contract that creates a financial asset in one entity. And that's what we're talking about. And an equity instrument or a financial liability in another entity. We're just talking about financial assets. And examples of financial assets include trade receivables, debtors, loans. If we have lent somebody money, normally we think of loans as a liability because we're a borrower. But the person who lent us the money, they have a financial asset. So loans can be a financial asset if you are the lender. If you've bought shares in another company, if you own equity shares, If you have that investment, that is a financial asset. And so are also investments in bonds or debentures, investments in debt. These are the classic examples of financial assets. So what's this got to do with Harry Potter? What's this got to do with the UK's first female prime minister? What's this got to do with the Hollywood superstar Will Smith? Well, we'll find out a little bit later on. But we know what financial assets are. And in this lecture, I don't want you to be scared. Yeah, there's my wife. She's scared. We're about to take off in a four-man plane to fly over Australia to have a look at the view. But it was a fantastic experience. And I hope this will be a fantastic experience too. We're going to look at the life cycle. of a financial asset and we're going to look at some numbers. We're going to understand through application. So when I talk about life cycle, I'm talking about a beginning, a middle and an end. And for a butterfly, they lay an egg and the egg becomes a caterpillar and the caterpillar becomes a pupa. But we're not here to learn about biology. We're here to learn about the life cycle of a financial asset. And in the beginning, you have to classify. So we have to give a name, a type, a classification to our financial assets. And that then determines how we initially measure them when we become a party to the contract. And having initially measured them, we've subsequently got to account for them. Are they going to be accounted for using a cost basis or a fair value basis? And what does that mean? And then, of course, at the end of their lives, they are de-recognized. So we've got to understand the process of death, the process of removing the financial asset from the accounts. So these are the four stages. This is the four stages. This is the life cycle of a financial asset. Now, let me give you the punchline. Let me tell you in advance that there are three categories of financial assets that we can classify them as. They can either be amortized cost, fair value through OCI, other comprehensive income, or fair value through P&L, fair value through profit and loss account. So that's the outcome. But how is it that we make the decision as to which of these three categories? that we're going to be classifying our financial assets. And the first step is to examine the nature of the financial asset and to understand what it is we've bought, what it is that we have control of. Is it something that's going to pump out to us regular cash? Are we going to receive contractual cash flows? on certain dates of certain amounts? Are we going to get our money back? Do we know when and how much that is going to be? Because that can be summarized as saying, are the payments solely the payment of principal and interest? So we do the cash flow test. It's the first thing we do when we've got a financial asset. Are the cash flows we're going to get fixed, certain, regular? Do they represent compensation for the time value of money? Do they represent compensation for the risk? Are we going to get our money back? Because if the answer is yes, we've lent them money. If the answer is yes, the nature of our financial asset is that it's a debt instrument. But if the answer is no, So we've got variable cash flows. We may or may not get our money back. Then effectively, we've invested in shares and that is then an equity type investment. So the first thing we do when we have a financial asset is to ask ourselves about the cash flow test. SPPI, are the cash flows solely the payment of principal and interest? And if the answer is yes, it's a debt instrument. And we then have to consider... why we've lent them the money, why we've bought that bond, why we've bought that debenture. And if the reason, if our business model is that we are going to keep that asset forever, that we're going to hold it and collect all of the money in and never sell it, if our business model is to keep it, then we don't care about the fair value. Because we're never going to sell it. So if the business model is definitely to keep it, then the classification is amortized cost. But if there's a hint, if there's a possibility that we might sell it if the value goes up, for example, or we might need the money down the line, if that's hinted at, then fair value is something that should be communicated to the stakeholders. Because we might sell it, so there's an accountability there as to what the fair value is. But we're not trading it. We're going to hold it for the long term. So the appropriate classification is fair value, but through OCI. Now, if it's neither of those two business models, presumably we're trading. Or if we don't know what our business model is, the default is to have it at fair value, but through P&L. So step two, if you know that it is a debt instrument, you have to consider the business model. But if you know it's not a debt instrument, in other words, it's an equity instrument, that you've bought shares in the company, then it must be at fair value. So we've got an interplay here with IFRS 13, how you arrive at their fair value, level one, level two, level three. Yeah, the market value hopefully is observed. but the instrument must be at fair value at every reporting date. And by re-measuring it at fair value, there's going to be a gain or a loss arising. And the default is that we classify it as fair value through P&L. That's the default. All right. If you've got an equity investment, you assume that it's fair value through P&L is the classification. Unless, unless an irrevocable decision is made at the beginning. to have it classified as fair value through OCI. And if that decision is made, then that's fine. Then that's how it's going to be accounted for. OK, so there is an element there of management choice. And I suppose I do. Well, we'll come back to that later as to why you might exercise that choice, why that choice might be more relevant in the circumstances. Let's have a look at a little bit of application. And this is a small example where we're going to have to make a decision about how we classify and account. And I've given it a kind of three mark benchmark, a three mark kind of indicator. So Clendon, my name, Clendon, Tom Clendon, Clendon has purchased some financial instruments for 100 million. So when you buy something, when you. hold a financial instrument, then it's going to be an asset because we've bought it. Now, our plan is to hold this. Yeah. And we have no plan to sell it. Now, the investment itself has a good track record of pumping out 10 percent. So the investors receive a regular return. And in fact, we have received 10 million this year. don't need a calculator to know that 10% of 100 is 10 million. And thirdly, we're told at the reporting date, the fair value of the investment was 125. Based on this information, we are going to have to discuss, so there may be more than one answer, we're evaluating, we're discussing, we're not just narrowly explaining, we're trying to broaden it slightly, discuss how Clinton should classify. and account. So there's an element of classification and there's an element of accounting. So I think about my answer plan. Now if we're going to be talking about classification in any written answer where we're talking about the classification of financial assets, you've got to explain that we have to consider the cash flow test whether the payments are solely the payment of... of principle and interest? Are they contractual? Are they certain? And there's a key wording in the question that says future returns are uncertain. So if the cash flow test is not met, by definition, we're looking at an equity investment. And how do we account for equity investments? We account for equity investments at fair value. and the fair value at the reporting date is 125. That's the figure that goes on the balance sheet. Of course it's a non-current asset because we've got no intention of selling it. It's not a trading item. The income that we received in the year of 10 million, of course it goes to the profit and loss account. But there's also the question of the capital value, the rise in value. Because we know that it's now worth 125, but we bought it for 100, there's a gain of 25. The default is to classify it as fair value through P&L, so that gain goes through the P&L. But if we do make an irrevocable election to have it classified as fair value through OCI, then the gain would go through other comprehensive income. And as an aside... I think I understand why management would sometimes want to elect for such an investment to be classified as fair value through OCI, because it will remove the swings and roundabouts. If you have it classified as fair value through OCI, you can be profit smoothing and have a regular, more predictable earnings and profits. you're not going to be including the revaluation gains and losses from the revaluation of such investments. And for that reason, earnings therefore become slightly more predictable, arguably therefore slightly more relevant, arguably therefore slightly more useful. So I kind of understand why the choice is there. It is annoying as a choice though, because it does reduce the comparability. Question one in the exam is going to be a pre-populated spreadsheet. And whilst question one in the exam has a big headline of it's all about groups, the reality of it is that anything can be tested within the pre-populated spreadsheet scenario. So I want you to think of this question. I want you to think of this being part of a question one where we have treated or the question has treated the investment as fair value through P&L when it should have been fair value through OCI? How is that going to affect the group profit and loss account? I wonder if you're ahead of me. You've got to take the 25 million out. The 10 million is fine. The 10 million dividend or income, whatever it was, that's fine. But the 25 million capital gain, if it's been treated as fair value through P&L, that's gone through the P&L, but it should have gone through OCI. So the adjustment is that we take 25 from investment income minus in a separate column in the P&L, but we're adding 25 to other comprehensive income. All right. So I think you've got to be able to think about these kind of things. Statement of financial position. If in the pre-populated spreadsheet, we've treated it as fair value through OCI, but it should have been P&L. What adjustment are you going to make? Well, if you've treated it as fair value through OCI, then the gain of 25 has gone directly to equity, is included in other components of equity. So you've got to take it out of other components of equity. because that gain should have gone through P&L if we're treating it as fair value through P&L. Therefore you should be adding it to retained earnings. Anything that goes through the P&L ends up ultimately on the balance sheet being reflected in retained earnings. Now the silent assumption that I've made is either this is a 100% owned sub or that the adjustment is in the accounts of the parent. The investment is held by the parent. So I'm not getting involved in non-controlling interest. There's a limit to what I want to talk about today. I want to keep it sharp. I want to keep it sweet and simple. So you now understand the classification process, amortized costs, fair value through OCI and fair value through P&L. Importantly involves considering the cash flow test. And if the cash flow test is passed, SPPPI, then you consider the business model. Now, initial measurement. We've got to go with rules here. Yeah. If you've classified it as amortized cost, you're initially recognizing it at the fair value plus TC, plus any transaction costs, any incremental costs, any costs that you've incurred in order to buy that financial asset. So that's very consistent with PPE. The rules under ISA 16 as well. Same applies if it is classified as a fair value through OCI investment. You would effectively capitalize any TC, capitalize any transaction costs. But if it's fair value through P&L, it's a kind of trading item and you're writing off those transaction costs. So the initial measurement is. fair value, the fair value of the consideration that you gave. Subsequent measurement, right? We're looking at the life cycle of financial assets. We've classified them. We've initially recognized them. And now we've got to know how we account for them in the future. So this is where I'm going to talk to you about Harry Potter, Margaret Thatcher, and William Smith. Potter is somebody who takes clay and makes them into pots. A thatcher is somebody who takes straw and makes it into a roof. A smith is somebody who takes metal and makes it into swords and metal objects. In other words, their name tells you what they do, what their original ancestors did. Their name... tells you what they do. And that is the same for financial assets. If you've classified it as amortized cost, you're going to account for it as amortized cost. You'll still call it a debtor on the balance sheet. You'll still call it an investment in bond on the balance sheet. But if you've classified it as amortized cost, you will account for it at amortized cost, up with the finance income, down with the cash. Closing balance doesn't change. If it's fair value through P&L, it has to be remeasured at fair value at each year end and the gain or loss go to P&L. If it's fair value through OCI, then again, it's at fair value at the year end and the gain or loss between the carrying value and the year end fair value will go to other comprehensive income. That's the story. That's the subsequent measurement. So it's worthwhile understanding the classification process because that automatically tells you the subsequent measurement. And I may as well finish off the story, the derecognition. is when you pass away the risks and rewards of ownership. And that becomes tested when we start to think about factoring. But that's not the subject of today's video. So when do you de-recognize a financial asset? It's not when you sell it. It's not when you pass away the legal title, although that may happen. But the point of de-recognition is when you no longer enjoy the benefits, when you no longer have... the risks and rewards of ownership and that's about substance and that's about faithful representation but i want to show you and take you through some numbers to take you through a practical example of a financial asset and i've given it some marks i've given it seven marks i'm giving it a requirement to explain and illustrate now I've been around the block, I've seen many, many exam questions, and my gut reaction is that the words normally carry more weight or more numbers, more marks than the numbers. So if it's seven marks, intuitively I'm going to think there's four marks for explaining and three marks for the numbers, and I'll try and show you how we end up. getting those individual marks in a moment. Fish has a year end. And at the beginning of the year, it's bought a 5% bond. So the 5% is the coupon rate. The 100,000 is the nominal value. But we've only paid 95,000. So we've bought it at a slight discount. The fair value of the consideration we've given is 95. The 5% on the 100,000 tells us that this will spit out cash of 5,000 a year. All right, that's the coupon rate on the nominal value. And that interest is received in arrears, in other words, at the end of the year. There are transaction costs. Now, the bond has a limited life and is ultimately redeemed at a premium of 5960. The effective rate of interest on this asset is 8%. So this bond is only going to be in existence for three years, the whole of X1, the whole of X2 and the whole of X3. Strictly speaking, the requirement is just to consider the first year. Now our intention is to hold the asset to maturity, but it is possible that we could sell it and then we're given two different fair values. If you need to pause the video, now is a good time to pause the video and think about how you're going to get ahead of the game and what these numbers mean and what the explanation is going to be. If I'm thinking about the explanation and I'm thinking about the words for four marks, I'm thinking in my head, this is my answer plan, how do we classify? SPPI? Are there... Payments contractual? Are they certain? Are they fixed? And if they are, what's the business model? And therefore, that tells me the accounting treatment and tells me the initial measurement. So classification. Does this meet the cash flow test? Yes, it does. You know you're going to get 5,000 every year. You know you're going to get your money back at the end. So it is a debt instrument. In substance, you've lent money to somebody. The nature of the investment, it's not equity. You're not taking a big risk. This is debt and you're going to get your money back. That is the contractual arrangement. And therefore, we have to consider the business model. And FISH may hold the asset to maturity, but at the same time, it may sell it as well. So therefore, fair value is relevant. And the appropriate accounting treatment is fair value through OCI. that means the initial recognition will capitalize the transaction costs. So that's the theory. That's the explanation. And in an exam scenario, that would need to be written up into short, sharp, simple sentences using the name fish, leaving space. A couple of marks for discussing SPPI, the cash flow test and coming to the right conclusion. Yeah, another mark. for dealing with the business model and a final mark for dealing with the transaction cost, the initial recognition. And if you understand the theory, you should then be able to apply it to the numbers because the initial recognition will be 7097. Yeah, because you capitalize the transaction costs of two. The subsequent accounting treatment therefore is going to be at amortized cost, which means that you will recognize as income 8% on the carrying value, 8% being the effective rate, but you would then deduct any cash that you've received, debit cash, credit asset, we're receiving 5,000. At the year end, you're remeasuring it to the fair value of 110, and then you have a gain or loss. that is taken directly to equity and reported in other comprehensive income as a balancing figure. Now what have I done here? It's the nature of me and the nature of a slidey presentation that what we've actually done here is almost explain it again. But I want to tell you that there are three marks for three numbers and you can earn those marks by identifying 97 by identifying as the profit and loss account income 8% of the 97. Now this is where own figure rule applies because if you take 8% of 95 you would lose the mark for the initial recognition but you would gain the mark for the income because the application is 8% on the opening value on the opening carrying value and again you Clearly going to gain the mark if you get the right balancing figure, but providing you get a balancing figure and you identify it correctly, whether it's a gain or a loss, in some ways it doesn't matter what that balancing figure is because you could have made a mistake in an earlier calculation and then obviously the balancing figure is wrong. The more traditional way or the best way in an exam scenario is to use the pre-populated spreadsheet that's on offer. and to present your working in this way and the working in this way would then earn you three out of three. And there's year one, you know, there's year one done. You've got a carrying value before the valuation of 99, your year-end value is 110 and you've got a gain or loss of 10. Now because we're dealing with an asset you really want to make sure that you understand that that 10,240 is again you're better off because the asset's gone up. Now strictly speaking seven out of seven strictly speaking I finished the question but I just want to show off I just want to dot the i cross the t help you understand don't go over the top in the exam. What happens in the second year is that you then get eight percent income on the opening balance of 110? No. So let me just clarify where that 7981 comes from. We're looking at the effective rate of interest of 8% as if it had been carried at amortized cost. And if it had been carried at amortized cost, you would have had 8% on the 99760. All right. That's where the number comes from. That's a little bit of a trick within the question that sometimes defeats people. All right. And that gives you ultimately as a balancing figure, 8981. OK, now that 8981 is the difference between you thought the carrying value was going to be 112, but actually it's 104. So that 8981 is a loss. In year three, if we had stuck originally with historical cost, if we had stuck originally with an amortized cost calculation, trust me, it's 8,219. This then gives you a cash flow that you're paying. back. Don't forget, you're paying back at a premium of 5960. So you're paying back the principal of 100. You're paying back the 5000 interest and you're paying back the premium of 5960. And therefore, the carrying value would have been, but you're having to wipe out that there is no carrying value. There is no asset at the end of year three. And therefore, that's the whole picture. So that's really dotting the I. And that's really crossing the T. Remember, the example only wanted the first year and you would have picked up all of the marks if you'd just done the first year. Doing the second year and third year is a teaching confidence issue. It's not something you would necessarily be asked to do in the exam. Right. What's next? Well, derecognition of assets is not something that I've talked about and I haven't also talked. about impairment of financial assets and expected credit losses in this in this video I can't cover everything in one short sharp session so that's two important areas around financial assets that you need to do some more work on and where are the resources for that well study hub you've got access to the study hub so go to chapter 8 yeah go to chapter 8 it's all on financial instruments. So you gain access to the ACCA study hub via your MyACCA. And we can see here in the chapters, yeah, chapter eight is where the financial instruments are dealt with. And look, they're 8.5, a story about credit losses. But there's more to the study hub than just chapters. Look. there's flashcards and of course there's one on financial assets and there's quizzes too but of course there's also questions to practice and this one suarez is on financial assets look at 8.4 That's the area on financial assets. Brush up your knowledge. Listen to my podcasts. I podcast on Spotify, Apple. I'm easily found Tom Clendon, ACCA, SBR. There's some free resources there on financial assets, on financial instruments. And of course, you've got the practice platform. All right. So, you know, when you are up to speed, when you're confident and ready to prepare for the exam, don't forget to do questions to time on the practice platform. Can you swim? Did you learn to swim by watching YouTube videos? Did you learn to swim? How did you learn to swim? By getting in the water, by doing it, by practicing it. The biggest mistake you can make is not making mistakes. You've got to get into that water, however cold it feels the first time. and ultimately to pass this exam it's application application application and you've got those questions to practice on the ACCA practice platform thank you very much for listening

some of the questions, you can get ahead of me in terms of my explanation. You're probably going to benefit from watching this video more than once. I hope you enjoy the show. Financial instruments seems to be always examined.

It's a massive topic and it can come up in words or numbers. So it's important that you understand the principles so you can explain them. And it can appear anywhere in the exam. Remember, every question in SBR is compulsory. So if it comes up, you've got to be able to deal with it.

Now, for the avoidance of any doubt, a financial instrument is a contract that creates a financial asset in one entity. And that's what we're talking about. And an equity instrument or a financial liability in another entity. We're just talking about financial assets.

And examples of financial assets include trade receivables, debtors, loans. If we have lent somebody money, normally we think of loans as a liability because we're a borrower. But the person who lent us the money, they have a financial asset.

So loans can be a financial asset if you are the lender. If you've bought shares in another company, if you own equity shares, If you have that investment, that is a financial asset. And so are also investments in bonds or debentures, investments in debt.

These are the classic examples of financial assets. So what's this got to do with Harry Potter? What's this got to do with the UK's first female prime minister? What's this got to do with the Hollywood superstar Will Smith?

Well, we'll find out a little bit later on. But we know what financial assets are. And in this lecture, I don't want you to be scared. Yeah, there's my wife.

She's scared. We're about to take off in a four-man plane to fly over Australia to have a look at the view. But it was a fantastic experience.

And I hope this will be a fantastic experience too. We're going to look at the life cycle. of a financial asset and we're going to look at some numbers.

We're going to understand through application. So when I talk about life cycle, I'm talking about a beginning, a middle and an end. And for a butterfly, they lay an egg and the egg becomes a caterpillar and the caterpillar becomes a pupa.

But we're not here to learn about biology. We're here to learn about the life cycle of a financial asset. And in the beginning, you have to classify. So we have to give a name, a type, a classification to our financial assets.

And that then determines how we initially measure them when we become a party to the contract. And having initially measured them, we've subsequently got to account for them. Are they going to be accounted for using a cost basis or a fair value basis?

And what does that mean? And then, of course, at the end of their lives, they are de-recognized. So we've got to understand the process of death, the process of removing the financial asset from the accounts.

So these are the four stages. This is the four stages. This is the life cycle of a financial asset. Now, let me give you the punchline. Let me tell you in advance that there are three categories of financial assets that we can classify them as.

They can either be amortized cost, fair value through OCI, other comprehensive income, or fair value through P&L, fair value through profit and loss account. So that's the outcome. But how is it that we make the decision as to which of these three categories?

that we're going to be classifying our financial assets. And the first step is to examine the nature of the financial asset and to understand what it is we've bought, what it is that we have control of. Is it something that's going to pump out to us regular cash? Are we going to receive contractual cash flows? on certain dates of certain amounts?

Are we going to get our money back? Do we know when and how much that is going to be? Because that can be summarized as saying, are the payments solely the payment of principal and interest? So we do the cash flow test.

It's the first thing we do when we've got a financial asset. Are the cash flows we're going to get fixed, certain, regular? Do they represent compensation for the time value of money?

Do they represent compensation for the risk? Are we going to get our money back? Because if the answer is yes, we've lent them money.

If the answer is yes, the nature of our financial asset is that it's a debt instrument. But if the answer is no, So we've got variable cash flows. We may or may not get our money back. Then effectively, we've invested in shares and that is then an equity type investment. So the first thing we do when we have a financial asset is to ask ourselves about the cash flow test.

SPPI, are the cash flows solely the payment of principal and interest? And if the answer is yes, it's a debt instrument. And we then have to consider...

why we've lent them the money, why we've bought that bond, why we've bought that debenture. And if the reason, if our business model is that we are going to keep that asset forever, that we're going to hold it and collect all of the money in and never sell it, if our business model is to keep it, then we don't care about the fair value. Because we're never going to sell it.

So if the business model is definitely to keep it, then the classification is amortized cost. But if there's a hint, if there's a possibility that we might sell it if the value goes up, for example, or we might need the money down the line, if that's hinted at, then fair value is something that should be communicated to the stakeholders. Because we might sell it, so there's an accountability there as to what the fair value is.

But we're not trading it. We're going to hold it for the long term. So the appropriate classification is fair value, but through OCI.

Now, if it's neither of those two business models, presumably we're trading. Or if we don't know what our business model is, the default is to have it at fair value, but through P&L. So step two, if you know that it is a debt instrument, you have to consider the business model.

But if you know it's not a debt instrument, in other words, it's an equity instrument, that you've bought shares in the company, then it must be at fair value. So we've got an interplay here with IFRS 13, how you arrive at their fair value, level one, level two, level three. Yeah, the market value hopefully is observed.

but the instrument must be at fair value at every reporting date. And by re-measuring it at fair value, there's going to be a gain or a loss arising. And the default is that we classify it as fair value through P&L.

That's the default. All right. If you've got an equity investment, you assume that it's fair value through P&L is the classification. Unless, unless an irrevocable decision is made at the beginning. to have it classified as fair value through OCI.

And if that decision is made, then that's fine. Then that's how it's going to be accounted for. OK, so there is an element there of management choice. And I suppose I do.

Well, we'll come back to that later as to why you might exercise that choice, why that choice might be more relevant in the circumstances. Let's have a look at a little bit of application. And this is a small example where we're going to have to make a decision about how we classify and account.

And I've given it a kind of three mark benchmark, a three mark kind of indicator. So Clendon, my name, Clendon, Tom Clendon, Clendon has purchased some financial instruments for 100 million. So when you buy something, when you.

hold a financial instrument, then it's going to be an asset because we've bought it. Now, our plan is to hold this. Yeah.

And we have no plan to sell it. Now, the investment itself has a good track record of pumping out 10 percent. So the investors receive a regular return.

And in fact, we have received 10 million this year. don't need a calculator to know that 10% of 100 is 10 million. And thirdly, we're told at the reporting date, the fair value of the investment was 125. Based on this information, we are going to have to discuss, so there may be more than one answer, we're evaluating, we're discussing, we're not just narrowly explaining, we're trying to broaden it slightly, discuss how Clinton should classify. and account. So there's an element of classification and there's an element of accounting.

So I think about my answer plan. Now if we're going to be talking about classification in any written answer where we're talking about the classification of financial assets, you've got to explain that we have to consider the cash flow test whether the payments are solely the payment of... of principle and interest?

Are they contractual? Are they certain? And there's a key wording in the question that says future returns are uncertain.

So if the cash flow test is not met, by definition, we're looking at an equity investment. And how do we account for equity investments? We account for equity investments at fair value.

and the fair value at the reporting date is 125. That's the figure that goes on the balance sheet. Of course it's a non-current asset because we've got no intention of selling it. It's not a trading item.

The income that we received in the year of 10 million, of course it goes to the profit and loss account. But there's also the question of the capital value, the rise in value. Because we know that it's now worth 125, but we bought it for 100, there's a gain of 25. The default is to classify it as fair value through P&L, so that gain goes through the P&L. But if we do make an irrevocable election to have it classified as fair value through OCI, then the gain would go through other comprehensive income. And as an aside...

I think I understand why management would sometimes want to elect for such an investment to be classified as fair value through OCI, because it will remove the swings and roundabouts. If you have it classified as fair value through OCI, you can be profit smoothing and have a regular, more predictable earnings and profits. you're not going to be including the revaluation gains and losses from the revaluation of such investments.

And for that reason, earnings therefore become slightly more predictable, arguably therefore slightly more relevant, arguably therefore slightly more useful. So I kind of understand why the choice is there. It is annoying as a choice though, because it does reduce the comparability. Question one in the exam is going to be a pre-populated spreadsheet.

And whilst question one in the exam has a big headline of it's all about groups, the reality of it is that anything can be tested within the pre-populated spreadsheet scenario. So I want you to think of this question. I want you to think of this being part of a question one where we have treated or the question has treated the investment as fair value through P&L when it should have been fair value through OCI?

How is that going to affect the group profit and loss account? I wonder if you're ahead of me. You've got to take the 25 million out.

The 10 million is fine. The 10 million dividend or income, whatever it was, that's fine. But the 25 million capital gain, if it's been treated as fair value through P&L, that's gone through the P&L, but it should have gone through OCI. So the adjustment is that we take 25 from investment income minus in a separate column in the P&L, but we're adding 25 to other comprehensive income.

All right. So I think you've got to be able to think about these kind of things. Statement of financial position. If in the pre-populated spreadsheet, we've treated it as fair value through OCI, but it should have been P&L.

What adjustment are you going to make? Well, if you've treated it as fair value through OCI, then the gain of 25 has gone directly to equity, is included in other components of equity. So you've got to take it out of other components of equity.

because that gain should have gone through P&L if we're treating it as fair value through P&L. Therefore you should be adding it to retained earnings. Anything that goes through the P&L ends up ultimately on the balance sheet being reflected in retained earnings.

Now the silent assumption that I've made is either this is a 100% owned sub or that the adjustment is in the accounts of the parent. The investment is held by the parent. So I'm not getting involved in non-controlling interest. There's a limit to what I want to talk about today. I want to keep it sharp.

I want to keep it sweet and simple. So you now understand the classification process, amortized costs, fair value through OCI and fair value through P&L. Importantly involves considering the cash flow test.

And if the cash flow test is passed, SPPPI, then you consider the business model. Now, initial measurement. We've got to go with rules here. Yeah. If you've classified it as amortized cost, you're initially recognizing it at the fair value plus TC, plus any transaction costs, any incremental costs, any costs that you've incurred in order to buy that financial asset.

So that's very consistent with PPE. The rules under ISA 16 as well. Same applies if it is classified as a fair value through OCI investment.

You would effectively capitalize any TC, capitalize any transaction costs. But if it's fair value through P&L, it's a kind of trading item and you're writing off those transaction costs. So the initial measurement is. fair value, the fair value of the consideration that you gave.

Subsequent measurement, right? We're looking at the life cycle of financial assets. We've classified them.

We've initially recognized them. And now we've got to know how we account for them in the future. So this is where I'm going to talk to you about Harry Potter, Margaret Thatcher, and William Smith. Potter is somebody who takes clay and makes them into pots. A thatcher is somebody who takes straw and makes it into a roof.

A smith is somebody who takes metal and makes it into swords and metal objects. In other words, their name tells you what they do, what their original ancestors did. Their name... tells you what they do. And that is the same for financial assets.

If you've classified it as amortized cost, you're going to account for it as amortized cost. You'll still call it a debtor on the balance sheet. You'll still call it an investment in bond on the balance sheet.

But if you've classified it as amortized cost, you will account for it at amortized cost, up with the finance income, down with the cash. Closing balance doesn't change. If it's fair value through P&L, it has to be remeasured at fair value at each year end and the gain or loss go to P&L. If it's fair value through OCI, then again, it's at fair value at the year end and the gain or loss between the carrying value and the year end fair value will go to other comprehensive income. That's the story.

That's the subsequent measurement. So it's worthwhile understanding the classification process because that automatically tells you the subsequent measurement. And I may as well finish off the story, the derecognition.

is when you pass away the risks and rewards of ownership. And that becomes tested when we start to think about factoring. But that's not the subject of today's video. So when do you de-recognize a financial asset?

It's not when you sell it. It's not when you pass away the legal title, although that may happen. But the point of de-recognition is when you no longer enjoy the benefits, when you no longer have... the risks and rewards of ownership and that's about substance and that's about faithful representation but i want to show you and take you through some numbers to take you through a practical example of a financial asset and i've given it some marks i've given it seven marks i'm giving it a requirement to explain and illustrate now I've been around the block, I've seen many, many exam questions, and my gut reaction is that the words normally carry more weight or more numbers, more marks than the numbers. So if it's seven marks, intuitively I'm going to think there's four marks for explaining and three marks for the numbers, and I'll try and show you how we end up.

getting those individual marks in a moment. Fish has a year end. And at the beginning of the year, it's bought a 5% bond.

So the 5% is the coupon rate. The 100,000 is the nominal value. But we've only paid 95,000. So we've bought it at a slight discount. The fair value of the consideration we've given is 95. The 5% on the 100,000 tells us that this will spit out cash of 5,000 a year.

All right, that's the coupon rate on the nominal value. And that interest is received in arrears, in other words, at the end of the year. There are transaction costs. Now, the bond has a limited life and is ultimately redeemed at a premium of 5960. The effective rate of interest on this asset is 8%. So this bond is only going to be in existence for three years, the whole of X1, the whole of X2 and the whole of X3.

Strictly speaking, the requirement is just to consider the first year. Now our intention is to hold the asset to maturity, but it is possible that we could sell it and then we're given two different fair values. If you need to pause the video, now is a good time to pause the video and think about how you're going to get ahead of the game and what these numbers mean and what the explanation is going to be. If I'm thinking about the explanation and I'm thinking about the words for four marks, I'm thinking in my head, this is my answer plan, how do we classify? SPPI?

Are there... Payments contractual? Are they certain? Are they fixed?

And if they are, what's the business model? And therefore, that tells me the accounting treatment and tells me the initial measurement. So classification.

Does this meet the cash flow test? Yes, it does. You know you're going to get 5,000 every year. You know you're going to get your money back at the end.

So it is a debt instrument. In substance, you've lent money to somebody. The nature of the investment, it's not equity. You're not taking a big risk.

This is debt and you're going to get your money back. That is the contractual arrangement. And therefore, we have to consider the business model. And FISH may hold the asset to maturity, but at the same time, it may sell it as well.

So therefore, fair value is relevant. And the appropriate accounting treatment is fair value through OCI. that means the initial recognition will capitalize the transaction costs.

So that's the theory. That's the explanation. And in an exam scenario, that would need to be written up into short, sharp, simple sentences using the name fish, leaving space. A couple of marks for discussing SPPI, the cash flow test and coming to the right conclusion.

Yeah, another mark. for dealing with the business model and a final mark for dealing with the transaction cost, the initial recognition. And if you understand the theory, you should then be able to apply it to the numbers because the initial recognition will be 7097. Yeah, because you capitalize the transaction costs of two.

The subsequent accounting treatment therefore is going to be at amortized cost, which means that you will recognize as income 8% on the carrying value, 8% being the effective rate, but you would then deduct any cash that you've received, debit cash, credit asset, we're receiving 5,000. At the year end, you're remeasuring it to the fair value of 110, and then you have a gain or loss. that is taken directly to equity and reported in other comprehensive income as a balancing figure. Now what have I done here? It's the nature of me and the nature of a slidey presentation that what we've actually done here is almost explain it again.

But I want to tell you that there are three marks for three numbers and you can earn those marks by identifying 97 by identifying as the profit and loss account income 8% of the 97. Now this is where own figure rule applies because if you take 8% of 95 you would lose the mark for the initial recognition but you would gain the mark for the income because the application is 8% on the opening value on the opening carrying value and again you Clearly going to gain the mark if you get the right balancing figure, but providing you get a balancing figure and you identify it correctly, whether it's a gain or a loss, in some ways it doesn't matter what that balancing figure is because you could have made a mistake in an earlier calculation and then obviously the balancing figure is wrong. The more traditional way or the best way in an exam scenario is to use the pre-populated spreadsheet that's on offer. and to present your working in this way and the working in this way would then earn you three out of three. And there's year one, you know, there's year one done.

You've got a carrying value before the valuation of 99, your year-end value is 110 and you've got a gain or loss of 10. Now because we're dealing with an asset you really want to make sure that you understand that that 10,240 is again you're better off because the asset's gone up. Now strictly speaking seven out of seven strictly speaking I finished the question but I just want to show off I just want to dot the i cross the t help you understand don't go over the top in the exam. What happens in the second year is that you then get eight percent income on the opening balance of 110?

No. So let me just clarify where that 7981 comes from. We're looking at the effective rate of interest of 8% as if it had been carried at amortized cost. And if it had been carried at amortized cost, you would have had 8% on the 99760. All right.

That's where the number comes from. That's a little bit of a trick within the question that sometimes defeats people. All right. And that gives you ultimately as a balancing figure, 8981. OK, now that 8981 is the difference between you thought the carrying value was going to be 112, but actually it's 104. So that 8981 is a loss. In year three, if we had stuck originally with historical cost, if we had stuck originally with an amortized cost calculation, trust me, it's 8,219.

This then gives you a cash flow that you're paying. back. Don't forget, you're paying back at a premium of 5960. So you're paying back the principal of 100. You're paying back the 5000 interest and you're paying back the premium of 5960. And therefore, the carrying value would have been, but you're having to wipe out that there is no carrying value.

There is no asset at the end of year three. And therefore, that's the whole picture. So that's really dotting the I. And that's really crossing the T.

Remember, the example only wanted the first year and you would have picked up all of the marks if you'd just done the first year. Doing the second year and third year is a teaching confidence issue. It's not something you would necessarily be asked to do in the exam. Right. What's next?

Well, derecognition of assets is not something that I've talked about and I haven't also talked. about impairment of financial assets and expected credit losses in this in this video I can't cover everything in one short sharp session so that's two important areas around financial assets that you need to do some more work on and where are the resources for that well study hub you've got access to the study hub so go to chapter 8 yeah go to chapter 8 it's all on financial instruments. So you gain access to the ACCA study hub via your MyACCA. And we can see here in the chapters, yeah, chapter eight is where the financial instruments are dealt with. And look, they're 8.5, a story about credit losses.

But there's more to the study hub than just chapters. Look. there's flashcards and of course there's one on financial assets and there's quizzes too but of course there's also questions to practice and this one suarez is on financial assets look at 8.4 That's the area on financial assets.

Brush up your knowledge. Listen to my podcasts. I podcast on Spotify, Apple.

I'm easily found Tom Clendon, ACCA, SBR. There's some free resources there on financial assets, on financial instruments. And of course, you've got the practice platform.

All right. So, you know, when you are up to speed, when you're confident and ready to prepare for the exam, don't forget to do questions to time on the practice platform. Can you swim?

Did you learn to swim by watching YouTube videos? Did you learn to swim? How did you learn to swim? By getting in the water, by doing it, by practicing it. The biggest mistake you can make is not making mistakes.

You've got to get into that water, however cold it feels the first time. and ultimately to pass this exam it's application application application and you've got those questions to practice on the ACCA practice platform thank you very much for listening

Transcript for:Overview of Financial Instruments and Their Importance

Transcript for:
Overview of Financial Instruments and Their Importance