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FA Amortised cost

IFRS 9 says that an investment in a debt instrument is measured at amortised cost if:
• The entity's business model is to collect the asset's contractual cash flows
– This means that the entity does not plan on selling the asset prior to maturity but rather intends to hold it until
redemption.
• The contractual terms of the financial asset give rise to cash flows that are solely payments of principal, and interest on the
principal amount outstanding
– For example, the interest rate on convertible bonds is lower than market rate because the holder of the bond gets the
benefit of choosing to take redemption in the form of cash or shares. The contractual cash flows are therefore not
Question 1
Paloma purchased a new financial asset on 31 December 20X3. The asset is a bond that will mature in three years. Paloma
buys debt investments with the intention of holding them to maturity although has, on occasion, sold some investments if
cash flow deteriorated beyond acceptable levels. The bond pays a market rate of interest. The Finance Director is unsure
as to whether this financial asset can be measured at amortised cost.
Required:
Advise the Finance Director on how the bond will be measured.
A debt instrument can be held at amortised cost if
• the entity intends to hold the financial asset to collect contractual cash flows, rather than selling it to realise fair
value changes.
• the contractual cash flows of the asset are solely payments of principal and interest based upon the principal
amount outstanding.
Paloma's objective is to hold the financial assets and collect the contractual cash flows. Making some sales when cash
flow deteriorates does not contradict that objective.
The bond pays a market level of interest, and therefore the interest payments received provide adequate compensation
for the time value of money or the credit risk associated with the principal amount outstanding.
This means that the asset can be measured at amortised cost.
Question 2
On 1 January 20X1, Tokyo bought a $100,000 5% bond for $95,000, incurring issue costs of $2,000. Interest is received in
arrears. The bond will be redeemed at a premium of $5,960 over nominal value on 31 December 20X3. The effective rate of
interest is 8%.
The fair value of the bond was as follows:
31/12/X1 $110,000
31/12/X2 $104,000
Required:
Explain, with calculations, how the bond will have been accounted for over all relevant years if:
(a) Tokyo's business model is to hold bonds until the redemption date.
(b) Tokyo's business model is to trade bonds in the short-term.
Assume that Tokyo sold this bond for its fair value on 1 January 20X2.
On 1 January 20X1, Magpie lends $2 million to an important supplier. The loan, which is interest-
free, will be repaid in two years’ time. The asset is classified to be measured at amortised cost. There
are no transaction fees.
Market rates of interest are 8%. The loss allowance is highly immaterial and can be ignored.
Required:
Explain the accounting entries that Magpie needs to post in the year ended 31 December 20X1 to
account for the above.
The loan is a financial asset because Magpie has a contractual right to receive cash in two years’ time.
Financial assets are initially recognised at fair value. Fair value is the price paid in an orderly transaction between market participants at the measurement date.
Market participants would receive 8% interest on loans of this type, whereas the loan made to the supplier is interest-free. It would seem that the transaction has not
occurred on fair value terms.
The financial asset will not be recognised at the price paid of $2 million as this is not the fair value. Instead, the fair value must be determined. This can be achieved by
calculating the present value of the future cash flows from the loan (discounted using a market rate of interest).
The financial asset will therefore be initially recognised at $1.71 million
($2m × 1/1.082). The entry required to record this is as follows:
Dr Financial asset $1.71m
Dr Profit or loss $0.29m
Cr Cash $2.00m
The financial asset is subsequently measured at amortised cost:
y/e Op bal Interest (8%) Receipt 31 Dec X1
Interest income of $0.14 million is recorded by posting the following:
Dr Financial asset $0.14m
Cr Profit or loss $0.14m
On 1 January 20X1 James issued a loan note with a $50,000 nominal value. It was issued at a discount of 16%
of nominal value. The costs of issue were $2,000. Interest of 5% of the nominal value is payable annually in
arrears. The bond must be redeemed on 1 January 20X6 (after 5 years) at a premium of $4,611.
The effective rate of interest is 12% per year.
Hoy raised finance on 1 January 20X1 by the issue of a two-year 2% bond with a nominal value of $10,000. It was issued at a
discount of 5% and is redeemable at a premium of $1,075. Issue costs can be ignored. The bond has an effective rate of
interest of 10%.
Wiggins raised finance by issuing $20,000 6% four-year loan notes on 1 January 20X4. The loan notes were issued at a
discount of 10%, and will be redeemed after four years at a premium of $1,015. The effective rate of interest is 12%. The issue
costs were $1,000.
Cavendish raised finance by issuing zero coupon bonds at par on 1 January 20X5 with a nominal value of $10,000. The bonds
will be redeemed after two years at a premium of $1,449. Issue costs can be ignored. The effective rate of interest is 7%.
The reporting date for each entity is 31 December.
Required:
Illustrate and explain how these financial instruments should be accounted for by each company.
Fair value through profit or loss
Out of the money derivatives and liabilities held for trading are measured at fair value through profit or loss.
It is also possible to measure a liability at fair value when it would normally be measured at amortised cost if it would eliminate or reduce an
accounting mismatch. In this case, IFRS 9 says that any movement in fair value is split into two components:
• the fair value change due to own credit risk (the risk that the entity which has issued the financial liability will be unable to repay or
discharge it), which is presented in other comprehensive income
• the remaining fair value change, which is presented in profit or loss.
On 1 January 20X1, McGrath issued a financial liability for its nominal value of $10 million. Interest is payable at a rate of 5% in arrears. The
liability is repayable on 31 December 20X3. McGrath trades financial liabilities in the short-term.
At 31 December 20X1, market rates of interest have risen to 10%.
Required:
Discuss the accounting treatment of the liability at 31 December 20X1.
Solution
The financial liability is traded in the short-term and so is measured at fair value through profit or loss.
The liability must be remeasured to fair value at the reporting date. Assuming that the fair value of the liability cannot be observed from an
active market, it can be calculated by discounting the future cash flows at a market rate of interest.
Date Cash flow ($m) Discount rate Present value ($m)
31/12/X2 0.5* 1/1.1 0.45
31/12/X3 10.5 1/1.12 8.68
* The interest payments are $10m × 5% = $0.5m
The fair value of the liability at the year-end is $9.13 million.
The following adjustment is required:
Dr Liability ($10m – $9.13m) $0.87m
Cr Profit or loss $0.87m
Bean regularly invests in assets that are measured at fair value through profit or loss. These asset purchases are funded by issuing bonds. If the
bonds were not remeasured to fair value, an accounting mismatch would arise. Therefore, Bean designates the bonds to be measured at fair
value through profit or loss.
The fair value of the bonds fell by $30m during the reporting period, of which $10m related to Bean's credit worthiness.
Required:
When a financial liability is designated to be measured at fair value through profit or loss to reduce an accounting mis-
match, the fair value movement must be split into:
• fair value movement due to own credit risk, which is presented in other comprehensive income (OCI)
• the remaining fair value movement, which is presented in profit or loss.
The value of Bean's liability will be reduced by $30 million. A credit of $10 million will be recorded in OCI and a credit of
$20 million will be recorded in profit or loss.
Craig issues a $100,000 4% three-year convertible loan on 1 January 20X6. The market rate of
interest for a similar loan without conversion rights is 8%. The conversion terms are one equity
share ($1 nominal value) for every $2 of debt. Conversion or redemption at par takes place on 31
December 20X8.
Required:
How should this be accounted for:
(a) if all holders elect for the conversion?
(b) no holders elect for the conversion?