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AFA 2019 Tutorial Financial Instruments incl suggested solutions.
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Advanced Financial Accounting 2019Tutorial Financial Instruments
Including suggested solutions
Entity Go-Below issues preference shares to the amount of €200 million. The preference shares
receive an annual 4% dividend. However, the Annual General Meeting of ordinary shareholders
can decide not to pay a dividend to the preference shareholders (in which case they are not
allowed to declare a dividend on the ordinary shares either). Holders of the preference shares can
ask for redemption after 10 year, not before and not after. In case they do, they are entitled to any
dividend that was not paid over the 10 year period. After the ten year period, for those that have
not exercised the redemption right, the dividend percentage increases to 5%.
A. How are the preference shares presented in Go-Below’s balance sheet?
1 As equity
2 As a liability
3. As a hybrid instrument
4 As a liability for the first 10 years, then as equity.
Company A issues redeemable preference shares. The preference shares are redeemable for cash
at the option of the issuer. The preference shares are entitled to a cumulative 6% dividend. A is
only required to pay a dividend on the preference shares if a dividend is paid on ordinary shares
for the relevant period (but if it pays dividend to the preference shareholders, it is required to pay
all outstanding passed dividend in the past as the dividend is cumulative). Company A is highly
profitable and has a history of paying ordinary dividends at a yield of about 4% annually without
fail for the past 25 years. Company A issued the preference shares after considering various
options to raise finance for building a new factory. The market interest rate for long-term debt at
the time the preference shares were issued was 7%.
B. Determine whether this financial instrument should be classified as a financial
liability or equity instrument of Company A. Give reasons for your answer.
This is an equity instrument. The issuer does not have a contractual obligation to either redeem
the shares or to pay dividends. This is so even though the substance of the instrument, when
considering all its terms and the circumstances of its issue, indicate that it is a liability.
, C. IFRS 7 requires entities to disclose a table indicating the extent to which receivables
are overdue. The purpose of this table is to provide the user insight into which risk?
1. Market risk
2. Liquidity risk
3. Credit risk
4. Interest rate risk
D. During the credit crisis the IASB received feedback from constituents that (i) IFRS
standards were pro-cyclical by requiring too much fair value and that (ii) under
IFRS loan loss provisions were recognised too little too late. Explain for each of those
two criticisms what changes were made to IFRS standards by the IASB to address
the concerns.
(i) Procyclical means that when measuring an instrument at fair value a significant
downward trend in the market may lead to a loss of trust in market parties,
thereby further decreasing the prices of instruments, leading to a spiral
movement downwards. The IASB responded by changing the classification and
measurement rules linking the measurement to the business model thereby
allowing instruments to be measured at cost when the intent is to keep the
instruments to collect cash flows rather than benefit from fair value movements
(ii) The incurred credit loss model was replaced by an expected credit loss model for
financial assets
E. For the following items, indicate whether these meet the definition of a financial
instrument and explain why:
(i) Trade receivable
(ii) Pension liability
(iii)Interest rate swap
(i) Yes, it is a contractual agreement between two trading parties where one party
has a financial asset (trade debtor) and the other party has a financial liability
(trade creditor).
(ii) No, although the employee is entitled to a certain amount, the arrangement
between employer and employee is conditional both in timing and amount, so
does not create a financial asset or a financial liability.
(iii) Yes, it is a contractual arrangement between two parties. One party acquires a
right to exchange a financial asset or liability with another party under
potentially favourable conditions. The other party takes on the right to exchange
under potentially unfavourable conditions.
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