Magazine article Financial Management (UK)

Paper F2 Financial Management: Although Some Aspects of the Accounting Standards Relating to Financial Instruments Are Complicated, You Will Still Pick Up Some Easy Marks If You Forget the Jargon and Focus on the Basic Calculations

Magazine article Financial Management (UK)

Paper F2 Financial Management: Although Some Aspects of the Accounting Standards Relating to Financial Instruments Are Complicated, You Will Still Pick Up Some Easy Marks If You Forget the Jargon and Focus on the Basic Calculations

Article excerpt

What is it about the term "financial instruments" that makes the average student panic? Many accountants simply need to know what a financial instrument is, when to recognise it in the accounts and how to measure it. And this is exactly what the examiner needs you to know.

Section B of the F2 syllabus covers issues in recognition and measurement. For financial instruments, this means that you need to be able to:

* Discuss the principle of substance over form applied to a range of transactions.

* Discuss the possible treatments of financial instruments in the accounts - ie, liability versus equity and the implications for finance costs.

Let's focus here on financial liabilities (a future article will cover financial assets, as there will be some syllabus changes after the issue of IFRS9). IAS32 tells us that a financial liability is any liability where the issuer is contractually obliged to deliver cash or another financial asset to the holder or to exchange financial instruments on potentially unfavourable terms. Examples you'll encounter include loans and debentures; redeemable preference shares; overdrafts; payables; and derivative instruments that are unfavourable. You'll also need to know how to deal with compound instruments - ie, those with elements of both debt and equity.

Having read the analysis and interpretation section of the syllabus, you'll know about the gearing ratio and what it says about a firm's relative levels of debt and equity. Debt includes redeemable preference shares, loans and debentures (overdrafts may be included if they're long-term finance sources). Equity includes ordinary and irredeemable preference shares, plus reserves and non-controlling interests for consolidation accounts. The gearing ratio is a good solvency gauge - an entity with a big debt is at risk if it can't make its loan and interest payments. So, if a firm wants to borrow more but is worried that its debt would deter lenders, it may try moving what is in essence a loan into the equity section of the statement of financial position by calling the loan a share, thereby making the gearing ratio look better. The accounting standards are there to ensure that, if an instrument is in essence a loan (no matter what the firm calls it), it's shown in the liability section because there's an obligation to repay it. That's why redeemable preference shares are treated as debt.

F2 exams regularly include questions about journal entries, which often trouble candidates. It's crucial that you know what the double entries are and also how to correct accounts where an entry has been omitted (as in November 2010's paper).

Loans, debentures and redeemable preference shares

These are all treated in the following way:

* Recognition: when the contract is entered into - ie, when the obligation is created.

* Initial measurement: proceeds received minus issue costs.

* Subsequent measurement: amortised cost using the effective interest rate. For full marks, always state both in any description. The amortised cost is the initial cost plus finance charges less actual interest or dividends paid (the coupon). The effective interest rate is the internal rate of return of the liability and will be given in the exam as a percentage. This figure simply allocates all the costs of servicing the liability (interest, issues costs and redemption premiums) over the accounting periods in which it is in issue. The recommended way to make the subsequent measurement is as follows:

Year             B/f         Effective        Coupon         C/f
                             interest        paid        (SOFP)
                               (IS)

1            Net proceeds             X           (X)           X

Journal           Dr Cash         Dr IS  Dr Liability           =
                                                        Liability
entry        Cr Liability  Cr Liability       Cr Cash

2                       X             X           (X)           X

n (year of              X             X           (X)  Redemption
redemption)                                                 value

* Presentation: the outstanding balance is a long-term liability (or current if it's due to be paid in the next 12 months) and the finance charge is an expense/debit to the income statement. …

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