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5 Example: Financial asset at amortised cost

5 Example: Financial asset at amortised cost

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The following table shows the allocation over the years:



Year

20X1

20X2

20X3

20X4

20X5



Amortised cost at

beginning of year

$

1,000

1,041

1,086

1,136

1,190



Profit or loss:

Interest income for

year (@10%)

$

100

104

109

113

119



Interest received

during year

(cash inflow)

$

(59)

(59)

(59)

(59)

(1,250 + 59)



Amortised cost

at end of year

$

1,041

1,086

1,136

1,190





Each year the carrying amount of the financial asset is increased by the interest income for the year and

reduced by the interest actually received during the year.

Investments whose fair value cannot be reliably measured should be measured at cost.



4.6 Financial assets measured at fair value

Where a financial asset is classified as measured at fair value, fair value is established at each period end

in accordance with IFRS 13 Fair value measurement. That standard requires that a fair value hierarchy is

applied with three levels of input:

Level 1 inputs. Unadjusted quoted prices in active markets for identical assets or liabilities that the entity can

access at the measurement date.

Level 2 inputs. Inputs other than quoted prices included within Level 1 that are observable for the asset or

liability, either directly or indirectly. These may include quoted prices for similar assets or liabilities in

active markets or quoted prices for identical or similar assets and liabilities in markets that are not active.

Level 3 inputs. Unobservable inputs for the asset or liability.

Any changes in fair value are normally recognised in profit or loss.

There are three exceptions to this rule:

(a)



The asset is part of a hedging relationship (see Section 6).



(b)



The financial asset is an investment in an equity instrument not held for trading. In this case the

entity can make an irrevocable election to recognise changes in the fair value in other

comprehensive income.



(c)



It is a financial asset measured at fair value through other comprehensive income because it

meets the criteria in 3.7.1 above, that is the financial asset is held within a business model whose

objective is achieved by both collecting contractual cash flows and selling financial assets.



Note that direct costs of acquisition are capitalised only in the case of a financial asset or financial liability

not held at fair value through profit or loss If the asset or liability is held at fair value through profit or loss,

the costs of acquisition are expensed. This means that in the case of financial assets held at amortised

cost, costs of acquisition are capitalised. They would be added to the asset and deducted from the

liability amount. Similarly, if an irrevocable election has been made to take gains and losses on the

financial asset to other comprehensive income, costs of acquisition should be added to the purchase

cost.



4.7 Example: Asset measurement

On 8 February 20X8 Orange Co acquires a quoted investment in the shares of Lemon Co with the intention

of holding it in the long term. The investment cost $850,000. At Orange Co's year end of 31 March 20X8,

the market price of an identical investment is $900,000. How is the asset initially and subsequently

measured?

Orange Co has elected to recognise changes in the fair value of the equity investment in other

comprehensive income.



Part B Accounting standards  7: Financial instruments



203



Solution









The asset is initially recognised at the fair value of the consideration, being $850,000

At the period end it is re-measured to $900,000

This results in the recognition of $50,000 in other comprehensive income



Question



Equity instrument and transaction costs



In January 20X6 Wolf purchased 10 million $1 listed equity shares in Hall at a price of $5 per share.

Transaction costs were $3m. Wolf’s year end is 30 November.

At 30 November 20X6, the shares in Hall were trading at $6.50. On 31 October 20X6 Wolf received a

dividend from Hall of 20c per share.

Show the financial statement extracts of Wolf at 30 November 20X6 relating to the investment in Hall on

the basis that:

(i)



The shares were bought for trading



(ii)



The shares were bought as a source of dividend income and were the subject of an irrevocable

election at initial recognition to recognise them at fair value through other comprehensive income.



Answer

(i)

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME (EXTRACT)

$m

Profit or loss for the year

Investment income (10m × (6.5 – 5.0))

Dividend income (10m × 20c)

Transaction costs



15

2

(3)



STATEMENT OF FINANCIAL POSITION (EXTRACT)

Investments in equity instruments (10m × 6.5)



65



(ii)

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME (EXTRACT)

$m

Profit or loss for the year

Dividend income

2

Other comprehensive income

Gain on investment in equity instruments



15



STATEMENT OF FINANCIAL POSITION (EXTRACT)

Investments in equity instruments

((10m × 6.5) + 3m)



68



4.7.1 Subsequent measurement of financial liabilities

After initial recognition, all financial liabilities should be measured at amortised cost, with the exception of

financial liabilities at fair value through profit or loss (including most derivatives). These should be

measured at fair value, but where the fair value is not capable of reliable measurement, they should be

measured at cost.

204



7: Financial instruments  Part B Accounting standards



4.8 Financial liabilities measured at amortised cost

The definitions of amortised cost, effective interest method and effective interest rate that are used for

measurement of financial assets are also used for financial liabilities.



4.9 Example: Financial liability at amortised cost

Galaxy Co issues a bond for $503,778 on 1 January 20X2. No interest is payable on the bond, but it will be

redeemed on 31 December 20X4 for $600,000. The effective interest rate of the bond is 6%.

Required

Calculate the charge to profit or loss of Galaxy Co for the year ended 31 December 20X2 and the balance

outstanding at 31 December 20X2.



Solution

The bond is a 'deep discount' bond and is a financial liability of Galaxy Co. It is measured at amortised

cost. Although there is no interest as such, the difference between the initial cost of the bond and the price

at which it will be redeemed is a finance cost. This must be allocated over the term of the bond at a

constant rate on the carrying amount.

The effective interest rate is 6%.

The charge to profit or loss for the year is $30,226 (503,778  6%)

The balance outstanding at 31 December 20X2 is $534,004 (503,778 + 30,226)



Question



Finance cost 1



On 1 January 20X3 Deferred issued $600,000 loan notes. Issue costs were $200. The loan notes do not

carry interest, but are redeemable at a premium of $152,389 on 31 December 20X4. The effective finance

cost of the debentures is 12%.

What is the finance cost in respect of the loan notes for the year ended 31 December 20X4?

A

B

C

D



$72,000

$76,194

$80,613

$80,640



Answer

C



The premium on redemption of the preferred shares represents a finance cost. The effective rate of

interest must be applied so that the debt is measured at amortised cost.

At the time of issue, the loan notes are recognised at their net proceeds of $599,800 (600,000 –

200).

The finance cost for the year ended 31 December 20X4 is calculated as follows:



20X3

20X4



B/f

$

599,800

671,776



Interest @ 12%

$

71,976

80,613



C/f

$

671,776

752,389



Part B Accounting standards  7: Financial instruments



205



Question



Finance cost 2



On 1 January 20X1, an entity issued a debt instrument with a coupon rate of 3.5% at a par value of

$6,000,000. The directly attributable costs of issue were $120,000. The debt instrument is repayable on

31 December 20X7 at a premium of $1,100,000.

What is the total amount of the finance cost associated with the debt instrument?

A

B

C

D



$1,470,000

$1,590,000

$2,570,000

$2,690,000



Answer

D

Issue costs

Interest $6,000,000  3.5%  7

Premium on redemption

Total finance cost



Question



$

120,000

1,470,000

1,100,000

2,690,000



Classification



During the financial year ended 28 February 20X5, MN issued the two financial instruments described

below. For each of the instruments, identify whether it should be classified as debt or equity, explaining in

not more than 40 words each the reason for your choice. In each case you should refer to the relevant

International Financial Reporting Standard.

(i)



Redeemable preference shares with a coupon rate 8%. The shares are redeemable on 28 February

20X9 at premium of 10%.



(ii)



A grant of share options to senior executives. The options may be exercised from 28 February

20X8.



Answer

(i)



Debt. The preference shares require regular distributions to the holders but more importantly have

the debt characteristic of being redeemable. Therefore, according to IAS 32 Financial instruments:

Presentation they must be classified as debt.



(ii)



Equity. According to IFRS 2 Share based payment the grant of share options must be recorded as

equity in the statement of financial position. It is an alternative method of payment to cash for the

provision of the services of the directors.



Question



Hybrid financial instrument



On 1 January 20X1, EFG issued 10,000 5% convertible bonds at their par value of $50 each. The bonds

will be redeemed on 1 January 20X6. Each bond is convertible at the option of the holder at any time

during the five-year period. Interest on the bond will be paid annually in arrears.

The prevailing market interest rate for similar debt without conversion options at the date of issue was

6%.

At what value should the equity element of the hybrid financial instrument be recognised in the financial

statements of EFG at the date of issue?



206



7: Financial instruments  Part B Accounting standards



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