Seminar 11; Questions - Solutions PDF

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Seminar 11: Solutions to Review Questions Chapter 14, Australian Financial Reporting, 7e: Questions 1, 2, 9, 10, 28 Question 1: Define financial instrument. A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. For example, if ABC Ltd took out a loan from XYZ Ltd the loan contract would represent a financial instrument, where ABC Ltd has a financial liability (loan payable) and XYZ Ltd has a financial asset (loan receivable). Question 2: What is a primary financial instrument? Provide some examples. A primary financial instrument is a financial instrument whose value is not derived from the value of another instrument. The value of a primary financial instrument can be directly determined by reference to the market. For example, trade receivables, trade payables and equity securities are primary financial instruments. Question 9: Is there a consequence for reported profit or loss if a particular financial instrument, for example, a preference share, is designated as debt rather than equity? Explain the consequence. Yes there is a consequence, both for the profit and loss and the financial position of the entity. For example, a consequence of recognising the preference shares as a financial liability rather than equity is that the associated periodic payments are an interest expense not dividends, so this classification affects both the income statement and the balance sheet of the issuer. All things being equal, the issuer would prefer to classify the preference shares as equity. AASB132 provides detailed further guidance on the classification of debt versus equity components of financial instruments (see pp. 465 – 469 of Deegan reading). Question 10: What does mark to market mean? Mark to market means that you value assets and/or liabilities according to market prices. Therefore, the recorded value of assets and liabilities that are ‘marked to market’ will change as the market prices change. Question 28: AASB 132 requires the issuing entity to classify a financial instrument, or its component parts, as a liability or as equity in accordance with the economic substance of the instrument at the time of initial recognition. What does this requirement actually mean? Paragraph 15 of AASB 132 states: The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset, or an equity

instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset, and an equity instrument. The phrase ‘economic substance over legal form’ requires the consideration of the economic reality of the transaction not just the legal form of the transaction. For example, if preference shares are issued that allow the holder of the preference shares to demand the issuer exchange the securities for cash, the economic substance of the transaction is that a liability should be recognised in the issuer’s accounts....