Exercise 1 - 3 solutions for TUT 102 PDF

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EXERCISE 1 - SOLUTION

Asset description Investment property

Financial asset? (Yes/No) No

Rationale It is not cash, not an equity instrument and not a contractual right to receive cash or a contract that will be settled in the entity’s own equity instruments.

Property, plant and equipment

No

It is not cash, not an equity instrument and not a contractual right to receive cash or a contract that will be settled in the entity’s own equity instruments.

Investment in debentures

Yes

There is a contractual right that give the entity the right to receive cash or equity instruments of another entity.

Investment in shares Investment in lease

Yes Yes

It is equity instruments of another entity

Inventory

No

There is a contractual right that gives the entity the right to receive cash. Although it creates the possibility of receiving cash or other financial assets, it does not reflect a contractual right to receive cash or another financial asset.

Accounts receivable

Yes

It represents a contractual right to receive cash from the debtors

Prepaid expenses

No

It does not represent a right to receive cash or other financial assets.

Cash/bank

Yes

A financial asset is defined as: (a) cash; (b) an equity instrument of another entity; (c) a contractual right to: receive cash or another financial asset from another entity; or exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or (d) certain contracts to be settled in the entity’s own equity instruments. It is cash in terms of IAS 32.11(a)

EXERCISE 2 SOLUTION Liability description

Lease liability

Financial liability? (Yes/No) Yes

Rationale

Loan payable

Yes

The entity is contractually obligated to settle the lease with cash

Issued debentures

Yes

Deferred tax liability

No

There is a contractual obligation to deliver cash to another entity with regard to redeemable debentures and a contract that will be settled in the entity’s own equity instrument with regard to convertible debentures A contractual obligation does not exist to deliver cash or another financial asset to another entity. It is a statutory obligation.

Trade payables

Yes

The entity is contractually obligated to settle the creditor with cash.

Income received in advance

No

The entity is not contractually obligated to deliver cash or another financial asset to another entity

Bank overdraft

Yes

The entity has a contractual obligation to settle the bank overdraft with cash

The entity is contractually obligated to settle the lease with cash

EXERCISE 3 -SOLUTION

Equity item Ordinary share capital

Preference share capital

Equity instrument? (Yes/No) Yes

Rationale It is a contact between the entity and the individual ordinary shareholders that gives the shareholders the residual interest in the assets of the entity after deducting all of its liabilities Preference shares can be classified as either equity, a financial liability, or a combination of the two. IAS 31.15 requires an entity to classify the financial instrument upon initial recognition - based on the substance over form principle. Preference shares could give rise to preference dividends and/or the right to receive cash or another financial instrument on redemption. You should consider these two legs (the preference dividends and the redemption) separately. 1st leg to consider: Preference dividends: - Non-discretionary (i.e mandatory): the issuer is not able to avoid the delivery of cash (dividend) thus the entity has an obligation to pay this dividend therefore, it meets the definition of a financial liability. - Discretionary: the issuer is able to avoid the delivery of cash (dividend) thus the entity does not have an obligation to pay the dividend. It therefore does not meet the definition of a financial liability. This means by default that the discretionary dividend meet the definition of an equity instrument. 2nd leg to consider: Redemption: - Non-redeemable: If there is no mandatory payment clause in the contract, it means that the entity can delay payment upon liquidation. The entity there has no contractual obligation to deliver cash or another financial asset on redemption, thus it does not meet the definition of a financial liability and by default meet the definition of an equity instrument. However, the classification of non-redeemable preference shares are not that clear cut. You also have to look at other rights attached to the preference share such as the cash flow of a

dividend before classification.

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If the preference shares are non-redeemable with mandatory dividends, the mandatory dividend might lead to financial liability classification. Thus, you have to look at the right attached to the share in combination. In such a case, it will be compound financial instrument because one part of the right (redemption) is meets the definition of equity but the other right attached to the mandatory dividend meets the definition of a financial liability. Thus if it is a non-redeemable preference share and the preference dividend is not mandatory (or a discretionary preference dividend) it will be a pure equity instrument.

Equity item Revaluation surplus

Equity instrument? (Yes/No) No

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Redeemable: Here it is important to look at whether the redemption is at the option of the holder or the issuing entity.

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In the case where the redemption is mandatory and at the option of the holder the issuing entity does not have an unconditional right to avoid the cash outflow on redemption. Although in the case of redeemable preference shares there is a contract between the entity and the individual preference shareholders, the contract does not give the shareholders the residual interest in the assets of the entity after deducting all of its liabilities. The preference shares is redeemable in cash on redemption and is therefore a financial liability.

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In the case where the redemption is mandatory and at the option of the issuer, the issuing entity have an unconditional right to avoid the cash outflow on redemption. The entity therefore has an obligation to deliver cash on redemption and thus meet the definition of a financial liability.

Rationale Revaluation surplus is equity as defined in the conceptual framework of IAS 1 but it is not an equity instrument as defined by IAS 32. Revaluation surplus does not fall in the scope of the definition of an equity instrument. The first part of the definition is that there must be a contract or transaction to give rise to an equity instrument.

Revaluation surplus does not arise as a result of a contract or transaction entered into with a third party.

Retained earnings

No

Retained earnings is equity as defined in the conceptual framework of IAS 1 but it is not an equity instrument as defined by IAS 32. Retained earnings does not fall in the scope of the definition of an equity instrument. The first part of the definition is that there must be a contract or transaction to give rise to an equity instrument. Retained earnings does not arise as a result of a contract or transaction entered into with a third party....