Business Finance Module 4
Business Finance Module 4
Business Finance Module 4
4
AND TAXES
i. Financial assets
ii. Financial liabilities
Learning Objectives: iii. Equity instruments
1. Explain the significance of interest rates as far as the While, Derivative financial instruments include, among others
economy the transfer of funds are concerned
2. Discuss the determinants of interest rates i. Options
3. Enumerate and explain the three components of the ii. Futures and forwards
money rate of interest on loans iii. Interest rate swaps
4. Explain the nature and impact of taxes on individuals and iv. Currency swaps
business firms
5. Describe what a financial instrument is
6. Describe and give examples of primary and derivative Assets
financial instruments
These are the sources controlled by the entity as a result of
7. Distinguish between
past events and from which future economic benefits are expected to
a) Financial VS. Non-financial assets
flow to the enterprise. These resources include financial assets such
b) Financial VS. Non-financial liabilities
as cash, receivables, or debt and equity securities of other enterprises
8. Describe and give examples of derivative financial
held by the entity as the investments. They also include non-financial
instruments
assets, such as inventory, property, plant and equipment, and
intangible assets.
FINANCIAL INSTRUMENTS
Financial instruments like stocks and bonds are recorded Assets should be classified into two: current assets and non-
evidence of obligations on which exchanges of resources are current assets.
founded. The effective investment management of these financial
PAS 1, paragraph 66, provides that an entity shall classify an asset as
instruments is one of the important aspects of the financing activities
current when:
of any organization.
a. The asset is cash or cash equivalent unless the asset is transactions which refers to the currency and coins which are in
restricted from being exchanged or used to settle a liability for circulation and legal tender.
at least twelve months after the reporting period.
However, in the accounting parlance, the term cash has a
b. The entity holds the asset primarily for the purpose of trading
special and broader meaning. Cash connotes more than money. As
c. The entity expects to realize the asset within twelve months
contemplated in accounting, cash includes money and any other
after the reporting period.
negotiable instrument that is payable in money and acceptable by the
d. The entity expects to realize the asset or intends to sell or
bank for deposit and immediate credit.
consume it within the entity’s normal operating cycle.
1. Cash on Hand
The line items under current assets are:
a. Undeposited cash collections– currencies such as
1. Cash and cash equivalents bills and coins, customers’ checks, traveller’s checks,
2. Financial Assets at Fair Value such as trading securities and manager’s checks, cashier’s checks, bank drafts,
other investments in quoted equity instruments money orders.
3. Trade and other receivables b. Working funds– cash funds segregated for current
4. Inventories use in the ordinary conduct of business.
5. Prepaid Expenses - Petty cash fund - Dividend fund
- Change fund - Tax fund
An entity shall classify all other assets as non-current.
- Payroll fund - Interest fun
Examples of non-current liabilities are:
2. Cash in Bank– include demand deposits. There are
1. Property, Plant and Equipment
unrestricted funds deposited in bank that can be withdrawn
2. Intangible Assets
upon demand such as amounts in checking and savings
account.
Current Assets
Cash Cash Equivalents
From the point of view of a layman, “cash” simply means PAS 7, paragraph 6, defines cash equivalents as short term,
money. Money is the standard medium of exchange in business highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of
changes in value. It further states that “only highly liquid investments Worthless accounts are recorded by debiting bad debts and
that are acquired three months before maturity can qualify as cash crediting accounts receivable.
equivalents.
Inventories
Receivables
PAS 2, paragraph 6, defines inventory as “assets which are
The classifications of receivables in the statement of financial position held for sale in the ordinary course of business; in the process of
are: production for such sale or in the form of materials or supplies to be
consumed in the production process or in the rendering of services.
1. Trade Receivables which are expected to be realized in cash
within the normal operating cycle or one year, whichever is The general rule is that all goods to which the entity has title
longer, are classified as current assets. shall be included in inventory, regardless of location.
2. Nontrade Receivables which are expected to be realized in
Two systems of Accounting for Inventories
cash within one year, the length of the operating cycle
notwithstanding, are classified as current assets. 1. Periodic or Physical system – calls for the physical counting
of goods on hand at the end of the accounting period to
If collectible beyond one year, nontrade receivables are
determine quantities.
classified as noncurrent assets.
2. Perpetual system – requires the keeping of stock cards that
Accounting for Bad Debts summarize inventory inflow and outflow.
The two methods of accounting for bad debts are the allowance The inventory cost flow assumptions acceptable under IFRS are:
method and direct write off method.
a. FIFO or First in, first out
1. Allowance method – requires recognition of bad debt loss if b. Weighted Average
accounts are doubtful of collection. c. Specific Identification
Mortgage Payable
This account records long-term debt of the business entity for
which the business entity has pledged certain assets as a security to Examples of Derivatives
the creditor.
Futures Contracts
A futures contract is an agreement between a seller and a
EQUITY INSTRUMENTS buyer that requires that seller to deliver a particular commodity (say
corn, gold, or beans) at a designated future date, at a predetermined
An equity instrument is any contract that evidences a residual
price. These contracts are actively treated on regulated future
interest in the assets of an entity after deducting all of its liabilities.
exchanges and are generally referred to as “commodity futures
Examples of Equity Instruments are: contract”. When the “commodity” is a financial instrument such as
Treasury bill or commercial paper, the agreement is referred to as a
Ordinary shares
financial futures contract. Futures contract are purchased either as an
Preference shares investment or as a hedge against the risks of future price changes.
Warrants or written call option that allow the holder to
subscribe or purchase ordinary shares in exchange for a fixed
amount of each or another financial asset. Forward contracts
A forward contact is similar to a futures contract but differs in three
DERIVATIVE FINANCIAL INSTRUMENTS ways:
Derivatives are financial instruments that “ derive” their value 1. A forward contract calls for a delivery on a specific date,
on contractually required cash flows from some other security or whereas a futures contact permits the seller to decide later
index. For instance, a contract allowing a company to purchase a which specific day within the specified month will be the
particular asset (say gold, flour, or coffee bean) at a designated future delivery date.
2. Unlike a futures contact, a forward is usually not traded on a There are contracts to exchange cash flows as of a specified
market exchange. date or a series of specified dates based on a notional amount and
3. Unlike a futures contract, a forward contract does not call for fixed and floating rates.
a daily cash settlement for price changes in the underlying
INTEREST RATES
contract. Gains and losses on forward contacts are paid only
when they are closed out. One of the most important factors affecting the transfer of
funds from savers to borrowers is interest rate. The interest rate is the
price paid for the use of money, and it is determined by the
Options combination of producers’ expected rates of return on invested capital
and consumers’ time preferences for consumption. Many factors go
Options give its holder the right either to buy or sell an
into making up the actual interest rate. It is composed of the real and
instrument, say a Treasury bill, at a specified price and within a given
risk free rate, plus premium to compensate investors for expected
time period. Options frequently are purchased to hedge exposure to
inflation, default risk, lack of liquidity risk and maturity risk.
the effects of changing interest rates. Option serves the same
purpose as futures in that respect but is fundamentally different.
How Interest Rates are Determined
Foreign Currency Futures Interest rates are determined by the demand for and supply of
loanable funds. Investors demand funds in order to finance capital
Foreign loans frequently are denominated in the currency of
assets that they believe will increase output and generate profit.
the lender (Japanese yen, Swiss franc, German mark, and so on).
Simultaneously, consumers demand loanable funds because they
When loans must be repaid in foreign currencies, a new element of
have a positive rate of time preference. They prefer earlier availability.
risk is introduced. This is because if exchange rates change, the peso
equivalent of the foreign currency that must be repaid differs from the
peso equivalent of the foreign currency borrowed.
Interest Rates and Risks
Inflationary premium
Pure interest