When you hear the term “Financial Instruments” you generally think of some complex derivative or advanced accounting scenario. But it’s a quite a straight forward area of the syllabus to understand, what perhaps is more difficult is applying to exam style questions in an exam situation.
What is a Financial Instrument?
A Financial Instrument is the name given to any contract that gives rise to both a financial asset in one company and a financial liability or equity instrument in another entity.
A simple way to illustrate a financial instrument would be the example of sales of goods from one company to another – the sales contract entered gives rise to a financial asset in one company (the receivable this is classed under current assets on the SOFP), meanwhile the other entity would have a payable in their books for the corresponding receivable (classed under current liabilities on the SOFP)
This is a financial instrument.
There are three main accounting standards that should be remembered when approaching questions on finance instruments.
- IAS 32: Financial instrument; presentation
- IAS 39: Financial instrument; recognition and measurement
- IFRS 7: Financial instrument; disclosures.
The video below from BPP gives a good practical example and steps to follow when trying to understand what type of financial instrument we are talking about and how to recognise and measure it <—– key to ensuring you can tackle the questions that come up in the CIMA F2 objective test.
As mentioned in the above video, a useful tip is to remember the four step approach when defining what type of financial instrument we are talking about and how to measure it.
- Is it a financial asset “purchased” or is it a financial liability/equity “issued”
- Which category does it fall under?
- What’s the initial measurement?
- What’s the subsequent measurement?
Here is an overview of the different categories financial assets and liabilities can fall under and how the initial and subsequent measurement is impacted based on this.
Exam Style Question
Taking into consideration the points made above, we can now tackle a CIMA F2 exam style objective test question.
- ABC Ltd. acquired 20,000 shares in another entity called DEF Ltd. during June 2000 for $3.52 per share.
- The investment was classed as available for sale on initial recognition.
- The shares were trading at $4.12 per share at year end 31 December 2000
- Commission of 6% of the value of transaction is payable on all disposals and purchases of shares.
Calculate the gain that would be credited to reserves in the year ended 31 December 2000 in respect of the above financial instrument.
Using the four step approach above:
- We have identified it’s a financial asset as it mentioned ABC “acquired”
- The financial asset is classed under the available for sale category.
- Therefore, initial measurement is fair value + transaction costs.
- And the subsequence measurement is fair value.
The scenario in the exam question can and most probably will be packed with information but if you take a pragmatic approach and pick out the information you need, then answering the question will be easier.
By taking the four step approach as outlined, we have understood what type of instrument we are measuring and how it should be measured. This gives the right method in calcuation the answer we need.
As it was an available for sale financial asset we only needed to add the transaction costs to the initial measurement and NOT to the subsequent measurement. This give ABC a total gain of $7,776 that should be credited to reserves.