Financial Instruments and Impairment
What you must know
Classify financial assets by business model and contractual cash flow characteristics: amortised cost (hold to collect, solely payments of principal and interest), fair value through OCI (hold to collect and sell, SPPI), and fair value through profit or loss (residual). Financial liabilities are generally at amortised cost unless held for trading or designated at fair value through profit or loss. Know the effective interest method, transaction costs, and the expected credit loss model (12-month ECL versus lifetime ECL, staging). Understand hedge accounting basics and the distinction between debt and equity instruments from the issuer's perspective.
Traps candidates fall into
- Classifying an equity investment at amortised cost.
- Ignoring the SPPI test when the business model suggests amortised cost.
- Expensing transaction costs on financial liabilities measured at amortised cost instead of including them in the carrying amount.
- Applying the general ECL model to trade receivables when the simplified approach is permitted.
- Forgetting to remeasure the loss allowance at each reporting date.
- Confusing fair value through OCI (debt) with fair value through OCI (equity, irrevocable election, no recycling).
Rule of thumb
Classify first by business model, then by the SPPI test. If either fails, use fair value through profit or loss. For impairment, always use forward-looking ECL, not just incurred losses.
Worked example
A bond is bought for 950,000 with transaction costs of 20,000, so the initial carrying amount is 970,000. Effective interest of 8% gives finance income of 77,600 in year 1. Coupon received is 60,000; the carrying amount rises to 987,600.
Consolidated Financial Statements and Business Combinations
What you must know
Control exists when the investor has power over the investee, exposure to variable returns, and the ability to use power to affect returns. Consolidate all subsidiaries. Apply the acquisition method: identify the acquirer, the acquisition date, recognise and measure identifiable assets and liabilities at fair value, and recognise goodwill (consideration plus non-controlling interest plus previously held interest, less net assets acquired) or a gain on a bargain purchase. Measure non-controlling interests at fair value or proportionate share of net assets. Eliminate intragroup balances, transactions and unrealised profits. Account for step acquisitions and disposals, and know the equity method for associates and joint ventures.
Traps candidates fall into
- Recognising goodwill on an associate; the equity method does not produce goodwill in the consolidated statements.
- Measuring NCI inconsistently between the parent and the subsidiary.
- Forgetting to eliminate unrealised profit on intragroup inventory sales.
- Treating control as ownership of more than 50% without considering substantive rights.
- Omitting contingent consideration at fair value at the acquisition date.
- Recognising a bargain purchase gain in OCI instead of profit or loss.
Rule of thumb
Goodwill = consideration transferred + NCI + previously held interest − fair value of identifiable net assets. If negative, recheck the valuation, then recognise a gain in profit or loss. Always eliminate intragroup profits before consolidating.
Worked example
Parent pays 900,000 for 80% of Subsidiary. Fair value of identifiable net assets is 1,000,000. NCI at proportionate share = 200,000. Goodwill = 900,000 + 200,000 − 1,000,000 = 100,000. If NCI were measured at fair value of 230,000, goodwill would be 130,000.
Financial Statement Analysis and Disclosure
What you must know
Compute and interpret profitability, liquidity, solvency and efficiency ratios: gross and net margin, return on assets and equity, current and quick ratios, gearing, interest cover, inventory turnover and receivables days. Use the DuPont decomposition (net margin × asset turnover × leverage) to explain return on equity. Understand limitations: historical cost, accounting policy choices, window dressing, and comparability problems. Know the disclosure requirements for accounting policies, judgements and estimation uncertainty, related parties, segment reporting and events after the reporting date (adjusting versus non-adjusting).
Traps candidates fall into
- Mixing average and closing balances in ratio denominators without stating the basis.
- Treating a non-adjusting event after the reporting date as requiring adjustment.
- Forgetting that a change in accounting estimate is applied prospectively, not retrospectively.
- Ignoring the effect of a share issue on EPS comparability.
- Presenting a related party transaction as an arm's length transaction when it is not.
- Overlooking off-balance-sheet obligations when assessing gearing.
Rule of thumb
State the formula and the basis (closing or average). For post-balance-sheet events, ask whether the condition existed at the reporting date: if yes, adjust; if no, disclose. Use DuPont to separate margin, turnover and leverage effects.
Worked example
Net profit 120,000; revenue 1,200,000; total assets 800,000; equity 400,000. Net margin = 10%; asset turnover = 1.5; leverage = 2.0. ROE = 10% × 1.5 × 2.0 = 30%, matching 120,000 / 400,000.