Advanced Financial
Accounting
An IFRS® Standards Approach, 3e
Pearl Tan, Chu Yeong Lim and Ee Wen Kuah
Solutions Manual
Chapter 9
Financial Instruments: Classification, Recognition and
Measurement
Copyright © 2016 by McGraw-Hill Education (Asia)
Advanced Financial Accounting (Tan, Lim and Kuah)
Chapter 9 solutions
CHAPTER 9
CONCEPT QUESTIONS
1
A mandatorily redeemable preference shares (MRPS) is a preference shares with the
following features:
• carries a fixed or determinable redemption date
• conditions for redemption are not solely within the control of the issuer.
Although the form of a MRPS is that of a preference share (equity), the substance of
the instrument is that of a liability. Under IAS 32, a MRPS is treated as a financial
liability and not as an equity instrument.
2
A compound financial instrument is a financial instrument with a debt component and
an equity component.
Under IAS 32, the debt component and the equity component of a compound financial
instrument are required to be separately recognized in the financial statements. The
rationale for splitting of the debt component from the equity component is that it
provides relevant information to users and reflects the effective borrowing costs of the
issuer.
The debt component is determined first by calculating the present value of cash flows
of the debt and the equity component is determined by deducting the fair value of the
debt component from the proceeds of the issue.
Financial assets are categorized into four categories:
(a) fair value through profit or loss
(b) held-to-maturity
(c) available-for-sale
(d) loans and receivables
3
4
5
Financial liabilities are categorized into:
(a) fair value through profit or loss
(b) other financial liabilities
6
Changes in the fair value of financial assets classified as fair value through profit or
loss are taken to income statement whereas changes in the fair value of available-forsale financial assets are taken to equity until they are disposed of. Financial assets
classified as fair value through profit or loss are short-term assets held for trading or
operation purposes. Therefore, it is appropriate that changes in their fair value are
taken to the income statement. Available-for-sale (AFS) financial assets are presumed
to be held indefinitely. By taking changes in the fair value of AFS to equity, volatility
in reported earnings is reduced.
7
Since the intention is to hold the financial asset to maturity, changes in the fair value
of the asset are not relevant to the holders.
8
Pros:
* consistent accounting treatment for all financial instruments
* complexities of hedge accounting are avoided.
Cons
* fair value does not provide relevant information for certain financial
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instruments that are intended to be held to maturity.
* determining fair value for all financial instruments could be costly.
9
(a)
(b)
(c)
(d)
No. The availability to the holder of the option to convert is inconsistent with
the presumed intention of holding to maturity.
Yes. The call option to the issuer, if exercised, merely alters the
maturity date of the instrument.
No. Holding for an indefinite period does not demonstrate intent to hold to
maturity.
No. Reits are not debt instruments.
10
(a)
(b)
(c)
(d)
(e)
Yes.
No. The sale is effected very near to the date of maturity.
No. The dispose was in response to a significant deterioration
in the credit worthiness of the issuer.
Yes; other securities in the portfolio are similarly ‘tainted’.
Yes, at the group level.
11
(a) The implementation of IAS 32 could be costly in the following ways:
1)
2)
3)
(b)
IAS 32 requires recognition of both debt and equity components. The debt
component usually gives rise to a discount on the bond which has to be amortise
using the effective interest rate method. The amortization of bond discount results
in higher financing expenses compared to pre-IAS 32 situation and results in
lower earnings reported. This may affect the price of the firm’s shares.
Cost of compound financial instrument is higher than the cost of debt. This may
raise the discount rate for the firm and affect the valuation of the firm if the
discounted cash flow method is used.
Direct costs of accounting for compound financial instruments will also increase –
the need to prepare amortization schedule, determine the effective cost of debt, etc.
In what ways may the implementation be beneficial for users of
financial statements?
Implementation of IAS 32 may benefit both informed/sophisticated users as
uninformed/naïve users. Without IAS 32 sophisticated investors/users would probably be
able to determine the true or effective borrowing cost of the firm although they may have to
incur costs to search for the information. With IAS 32 this ‘searching’ costs is saved. Naïve
or uninformed users will benefit from disclosure of the true or effective cost of financing
without having to incur cost.
The firm and its shareholders would probably benefit from IAS 32 as its implementation may
force management to use a higher discount rate (reflective of the true cost of capital) to
evaluate new projects.
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(c)
Why is the FASB’s stand a controversial issue?
The FASB’s stand is not to recognize the separate debt and equity components in compound
financial instruments. This stand implicitly ignores the principal of substance over form.
FASB’s arguments for non-splitting of CFIs are that the two instruments are inseparable and
the estimation of the cost of the equity component may be unreliable.
12. IAS 39 – Held-to-maturity (HTM), Available for sale (AFS), FVTPL
In terms of measurement methods, the three categories of IFRS 9 correspond to IAS 39 as
follows: IFRS 9 amortized cost category corresponds to IAS 39 HTM category, IFRS 9
FVTOCI (Fair value to OCI) category corresponds to IAS 39 AFS category, IFRS 9 FVTPL
category corresponds to IAS 39 FVTPL category.
The key differences lie in how financial assets are classified in the three categories. IFRS 9
requires business model and contractual cash flow tests to be satisfied for a debt security to
be classified as amortized cost. If the debt security is held for sale, it is classified in FVTPL
category. If the debt security is held to collect contractual cash flows and for sale, it is
classified in FVTOCI category. Equity security can be classified as either FVTOCI (if it is
not held for trading) or FVTPL but not amortized cost.
13. There have been criticisms that the incurred loan loss provisioning method tends to delay
loss recognition. The criticisms became sharper during the financial crisis. The expected loan
loss provisioning method is aimed at addressing this concern, and to recognize loan
provisions on a timely basis.
However, the downside of the expected loan provisions method is that the loan provisions are
more subjective and could be managed by bank managers. Thus the advantage of the incurred
loan provisions method is that it is more objective and less subject to earnings management.
14. The three categories are:
(i) Financial instruments that have not deteriorated significantly in credit quality from initial
recognition to reporting date,
(ii) Financial instruments with significant deterioration in credit quality from initial
recognition to reporting date,
(iii) Objective evidence of impairment.
Key factors in determining expected credit losses:
Change in probability of credit default from initial recognition to reporting date and loss
recovery. The probability of credit default is determined from credit risk profiles, credit risk
ratings, and risk characteristics of borrower including its financial health. Loss recovery is
affected by collaterals and guarantees that borrower has obtained.
15. In a securitization process, the originators place their assets in a securitization entity. The
latter sells the securitized assets in tranches to investors, who provide financing to the
securitization entity. One key objective of securitization is for originators to free up assets
from their books.
16. Yes, the mortgage backed security is a contractually linked financial instrument. The
mortgage backed security tranches originate from mortgage loans which are contractual cash
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flows. The prepayment of mortgage backed securities is based on prepayment of underlying
mortgage loans.
17.
(a) Convertible bond – level 3 because the issuer is a private company and there may not be
similar bonds issued by the same private company
(b) Inactive stock in emerging market – level 2 because while inactive, stock prices are
available
(c) Asset backed securities – level 3 because the prices have to be derived from models
(d) Non-deliverable forwards – level 2 because the prices are derived from spot rates and
swap points
(e) Spot rates of currencies actively traded – level 1 if the prices are directly obtained from
market
(f) USD/EUR cross currency swaps – level 2 because the prices are derived from spot rates
and swap points
(g) Credit default swaps – level 3 because prices need to be determined from probabilities of
default and recovery rates
(h) Equity-linked products – level 2 because while prices are available from brokers, the
market is not liquid
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PROBLEMS
Problem 9.1
The application of IAS 32 requires that the convertible bond be separated into a debt
component and an equity component.
The debt component is calculated as follows:
Present value of 10 semiannual interest payments
Present value of principal at maturity
Discount on bond (also = to equity component)
$1,312,810
7,811,984
$9,124,794
$ 875,206
Amortisation schedule of bond discount
Date
Coupon
interest
(a)
1/1/x0
30/6/x0
31/12/x0
30/6/x1
31/12/x1
30/6/x2
31/12/x2
30/6/x3
31/12/x3
30/6/x4
31/12/x4
150,000
150,000
150,000
150,000
150,000
150,000
150,000
150,000
150,000
150,000
Effective
interest
(b)
Amortisation
Of bond
discount
C = b -a
228,120
230,073
232,075
234,127
236,230
238,385
240,595
242,860
245,181
247,560
78,120
80,073
82,075
84,127
86,230
88,385
90,595
92,860
95,181
97,560
Unamortized
Bond
Discount
Carrying
value of bond
$875,206
797,086
717,013
634,939
550,812
464,582
376,197
285,601
192,742
97,560
0
9,124,794
9,202,914
9,282,987
9,365,061
9,449,188
9,535,418
9,623,803
9,714,399
9,807,258
9,902,440
10,000,000
Superior Corporation
Balance sheet (adjusted)
As at 31.12.20x2
Non-current assets
Current assets
20,000,000
8,000,000
28,000,000
Current liabilities
Non-current liability
6,000,000
9,623,803
15,623,803
Share capital
Retained earnings
Cap. Reserves –equity option
10,000,000
1,500,991 (Note a)
875,206
28,000,000
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Note (a):
Retained earnings (unadjusted)
Less amortized bond discount:
20x0
20x1
20x2
2,000,000
(158,193)
(166,202)
(174,616*)
1,500,991
* rounding difference of 1
(b) 30% of bonds converted
(Note: AG32 On conversion of a convertible instrument at maturity, the entity derecognises
the liability component and recognises it as equity. The original equity component remains as
equity (although it may be transferred from one item within equity to another. In this case,
although the conversion was not at maturity date, the same principle applies).
Amortisation schedule with partial conversion
Date
Coupon
Effective
Amortisation
Unamortized
Interest
interest
of bond
Discount
c = b –a
Bond
discount
(a)
(b)
1/1/x0
30/6/x0
31/12/x0
30/6/x1
31/12/x1
30/6/x2
Partial
31/12/x2
30/6/x3
31/12/x3
30/6/x4
150,000
150,000
150,000
150,000
150,000
conversion
105,000
105,000
105,000
105,000
228,120
230,073
232,075
234,127
236,230
of 30% of
166,870
168,417
170,002
171,627
31/12/x4
105,000
173,291*
Carrying
value of
bond
61,870
63,417
65,002
66,627
$875,206
797,086
717,013
634,939
550,812
464,582
-139,375
263,337
199,920
134,918
68,291
9,124,794
9,202,914
9,282,987
9,365,061
9,449,188
9,535,418
-2,860,625
6,736,663
6,800,080
6,865,082
6,933,373
68,291
0
7,000,000
78,120
80,073
82,075
84,127
86,230
Bond
Superior Corporation
Equity section of balance sheet (proforma)
As at 31.12.20x2
Shareholders’ equity:
Share capital
Retained earnings
Cap. Reserves
Total equity
13,123,187 (Note a)
1,572,506 (Note b)
612,644 (Note c)
15,308,337
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Notes:
(a) Share capital at 1/1/20x2
30% of carrying value of bond converted
(b) Retained earnings
Unadjusted balance
Interest for 20x2 saved (net of tax)
Amortized bond discount
20x0
20x1
20x2
10,000,000
3.123.187
13.123.187
2,000,000
45,000*
(158,193)
(166,202)
(148,099**)
1,572,506
(b) * With the partial conversion of 30% of the bonds, there is a
saving of $45,000 interest expense which increases the current
assets.
** rounding difference of 1. Taxation is ignored.
(c) Capital reserves –equity option remaining is 70% of the original capital reserves
(c) Journal entries 20x2
30/6/20x2
Dr
Interest expense
150,000
Dr
Amortization of discount
86,230
Cr
Cash
150,000
Cr
Unamortized bond discount
86,230
(Record interest expense and amortization of bond discount)
Dr
Capital reserves
262,562
Dr
Bond payable
2,860,625
Cr
Share capital
(Record conversion of 30% of bond)
3,123,187
31/12/20x2
Dr
Interest expense
105,000
Dr
Amortization of discount
61,870
Cr
Cash
105,000
Cr
Unamortized bond discount
61,870
(Record interest expense and amortization of bond discount)
Problem 9.2
(1)
Calculation of fair value of bond:
PV of interest payments [$100,000 x 8.752064] = $ 875,210
PV of principal: $10,000,000 x 0.781198
= 7,811,980*
PV of bond
= $8,687,190 * rounded to nearest 10
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Bond amortization schedule
Date
01-01-x0
30-06-x0
31-12-x0
30-06-x1
31-12-x1
30-06-x2
31-12-x2
30-06-x3
31-12-x3
30-06-x4
31-12-x4
Cash
Interest
Effective
Interest
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
217,180
220,109
223,112
226,190
229,345
232,578
235,893
239,290
242,772
246,341
Amortized
Discount
117,180
120,109
123,112
126,190
129,345
132,578
135,893
139,290
142,772
146,341
Unamortized
discount
1,312,810
1,195,630
1,075,521
952,409
826,219
696,874
564,296
428,404
289,114
146,341
0
Carrying
value of
bond
8,687,190
8,804,370
8,924,479
9,047,591
9,173,781
9,303,126
9,435,704
9,571,596
9,710,886
9,853,659
10,000,000
(2) Interest expense for 20x1:
$223,112 + $226,190 = $449,302
(3) The fair value of the bond yielding 3% effective interest rate is $9,760,865
calculated as follows:
PV of remaining interest payments: 100,000 x 4.782645 = 478,265
PV of principal at maturity: $10,000,000 x 0.92826
= 9,282,600
$9,760,865
Difference between fair value and carrying value of debt component:
Fair value of debt at 01/07/x2 =
Carrying value of debt 01/07/x2 =
Difference
$9,760,865
9,303,126
$457,739
The carrying value of debt and equity components is as follows:
Carrying values of:
Debt component
Equity component
9,303,126
1,312,810
$10,615,936
SummerBee should retire the debt only if the redemption price is less than $10,615,936.
(4)
Assuming that SummerBee retires the bond at a redemption price of $10,300,000 the
journal entries to record the redemption are as follows:
Journal entries:
Dr
Dr
Bond payable
Bond redemption expense
10,000,000
457,739*
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Cr
Unamortized discount
696,874
Cr
Cash
9,760,865
[To record the repurchase of the debt component of the compound financial
instrument]
*difference between fair value and carrying value of debt
Dr
Capital reserve
539,135
Cr
Cash
539,135
[To record the repurchase of the equity component: $10,300,000 - $9,760,865]
Problem 9.3
Calculation of fair value of bond:
(1) Fair value at 31/12/20x0 =
FV
=
=
=
$1,019,964
$85,000 x PVIFA,8%,5 years + PVF,8%,5 years
$85,000 x 3.99271 + $1,000,000 x 0.680583
$1,019,964
Fair value of bond at 31.12.20x1
FV
=
=
=
$85,000 x PVIFA,6%,4 years + PVF,6%,4 years
$85,000 x 3.465106 + $1,000,000 x 0.792094
$1,086,628
Fair value of bond at 31.12.20x2
FV
=
$85,000 x PVIFA,5%,3 years + PVF,5%,3 years
=
$85,000 x 2.723245 + $1,000,000 x 0.86384
=
$1,095,316
Sixty percent thereon = 60% * $1,095,316 = $657,189
(2)
Journal entries
31/12/20x0
Dr
Investment (AFS)
Cr
Cash
(Record investment in bond)
1,019,964
1,019,964
31/12/20x1
Dr
Cash
85,000
Cr
Investment
3,403
Cr
Interest income
81,597
(Record interest income using effective interest rate method and amortization of bond
premium(see amortization table).
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Dr
Investment
70,067
Cr
Deferred gain -Equity
70,067
(Adjust fair value of bond: [$1,086,628 – $1,019,964 + $3,403])
Date
31.12.20x0
Coupon
Interest
(8.5%)
Effective
interest
(8%)
Amortization
of bond
premium
Unamortized
Bond carrying
bond premium
19,964
Value
1,019,964
31.12.20x1
85,000
81,597
3,403
16,561
1,016,561
31.12.20x2
85,000
81,325
3,675
12,886
1,012,886
31.12.20x3
85,000
81,031
3,969
8,917
1,008,917
31.12.20x4
85,000
80,713
4,287
4,630
1,004,630
31.12.20x5
85,000
80,370
4,630
-
1,000,000
Journal entries for 20x2
31.12.20x2
Dr
Cash
85,000
Cr
Investment
3,675
Cr
Interest income
81,325
[Record interest income and adjustment to bond carrying value. Note: the effective interest is
the effective interest at the date of purchase of the bond.]
Dr
Investment
12,363
Cr
Deferred gain - Equity
12,363
(Fair value adjustment of investment:
[$1,095,316 -$1,082,953])
Dr
Cash
438,126
Cr
Investment (AFS)
(Sale of 40% of bonds: $1,095,316 x 0.4))
438,126
Dr
HTM
657,190
Cr
AFS
657,190
[Reclassification of balance of 60% of the bonds from available-for-sale to held-to-maturity]
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Problem 9.4
1 October 20x4
Dr Investment (AFS)
358,400
Cr Cash
358,400
(Investment in Scotts Corporation classified as available-for-sale: 100,000 x 2.8 x
1.28)
31 December 20x4
Dr Investment (AFS)
4,600
Cr Fair value reserves – equity
4,600
[Adjust carrying value of AFS to fair value and change in fair value to equity:
$363,000 - $358,400)
Dr Dividends receivable
12,100
Cr Dividend income
(Dividends declared: 10,000 x 1.21)
12,100
1 March 20x5
Dr Cash
12,050
Dr Exchange loss on dividend
50
Cr Dividends receivable
12,100
(Dividend received and exchange loss on dividend)
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Problem 9.5
(1) Effective interest rate
Per half- year 1.0587%
Per annum 2.1174%
(2) Amortization table
Date
01-Jul-06
31-Dec-06
30-Jun-07
31-Dec-07
30-Jun-08
31-Dec-08
30-Jun-09
31-Dec-09
30-Jun-10
31-Dec-10
30-Jun-11
Cash
interest
1.5% per
half-year
Effective
Amortization
interest
1.0587%
per half-year
180,000
180,000
180,000
180,000
180,000
180,000
180,000
180,000
180,000
180,000
1,800,000
132,338
131,833
131,323
130,808
130,287
129,760
129,229
128,691
128,148
127,584
47,663
48,167
48,677
49,192
49,713
50,240
50,771
51,309
51,852
52,416
1,300,000
500,000
Unamortized
premium
500,000
452,338
404,170
355,493
306,301
256,588
206,348
155,577
104,268
52,416
0
Principal
Carrying
amount
12,000,000
12,000,000
12,000,000
12,000,000
12,000,000
12,000,000
12,000,000
12,000,000
12,000,000
12,000,000
12,000,000
12,500,000
12,452,338
12,404,170
12,355,493
12,306,301
12,256,588
12,206,348
12,155,577
12,104,268
12,052,416
12,000,000
Fair
value
$11,510,266
$11,139,584
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(3) Fair value of MRPS
31-Dec-06
Prevailing interest rate
Fair value (present value)
Payment
Periods
Future value
2% per half-year
$11,510,266
180,000
9
12,000,000
30-Jun-07
Prevailing interest rate
Fair value (present value)
Payment
Periods
Future value
2.5% per half-year
$11,139,584
180,000
8
12,000,000
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(4) Income Statement effects
(a) HTM
31-Dec-06
Interest income
Fair value adj
(b) AFS
132,338
132,338
132,338
132,338
(Journal entries are not required but are useful)
Dr Cash
180,000
Cr MRPS
Cr Interest income
(c) FVTPL
132,338
($942,072)
-809,734
180,000
180,000
132,338
180,000
47,663
132,338
Dr Fair value loss
Cr MRPS
47,663
132,338
$942,072
$942,072
Dr Deferred loss (equity)
Cr MRPS
$942,072
$942,072
30-Jun-07
Interest income
Loss in fair value
131,833
131,833
131,833
131,833
131,833
($322,515)
-190,682
(Journal entries are not required but are useful)
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(a) HTM
180,000
Dr Cash
Cr Unamortized premium
Cr MRPS
Cr Interest income
(b) AFS
180,000
(c) FVTPL
180,000
48,167
48,167
131,833
131,833
Dr Fair value loss
Cr MRPS
48,167
131,833
$322,515
$322,515
Dr Deferred loss
Cr MRPS
$322,515
$322,515
(5) Balance sheet effects
(a) HTM
(b) AFS
(c) FVTPL
31-Dec-06
Assets
MRPS
Cash
12,452,338
-12,320,000
$11,510,266
-12,320,000
$11,510,266
-12,320,000
132,338
-809,734
-809,734
132,338
132,338
($942,072)
132,338
-809,734
-809,734
-809,734
Equity
Deferred loss (AFS)
P&L
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Chapter 9 solutions
31-Dec-07
(a) HTM
Assets
MRPS
DCash
Equity
Deferred loss (AFS)
DP&L
Beginning RE
(b) AFS
(c) FVTPL
12,404,170
-12,140,000
264,170
$11,139,584
-12,140,000
-1,000,416
$11,139,584
-12,140,000
-1,000,416
131,833
132,338
264,170
($1,264,587)
131,833
132,338
-1,000,416
-190,682
-809,734
-1,000,416
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Chapter 9 solutions
Problem 9.6
(1) Compound financial instrument that has a debt element
(mandatory redemption) and equity option (conversion feature)
(2) Amortization table: as per normal with the following key variables
Carrying amount at inception
11,446,669
Principal amount:
12,000,000
Unamortized discount:
553,331
Effective interest
1.50%
Coupon interest:
1%
Date
Cash
Effective
Amortization
interest
interest
1.0% per
Principal amount:
half-year
per half-year
Unamortized
Principal
discount
01-Jul-06
Carrying
amount
-553,331
12,000,000
11,446,669
31-Dec-06
120,000
171,700
51,700
-501,631
12,000,000
11,498,369
30-Jun-07
120,000
172,476
52,476
-449,156
12,000,000
11,550,844
31-Dec-07
120,000
173,263
53,263
-395,893
12,000,000
11,604,107
30-Jun-08
120,000
174,062
54,062
-341,831
12,000,000
11,658,169
31-Dec-08
120,000
174,873
54,873
-286,959
12,000,000
11,713,041
30-Jun-09
120,000
175,696
55,696
-231,263
12,000,000
11,768,737
31-Dec-09
120,000
176,531
56,531
-174,732
12,000,000
11,825,268
30-Jun-10
120,000
177,379
57,379
-117,353
12,000,000
11,882,647
31-Dec-10
120,000
178,240
58,240
-59,113
12,000,000
11,940,887
30-Jun-11
120,000
179,113
59,113
0
12,000,000
12,000,000
1,200,000
1,753,331
553,331
(3) Show the journal entries in Co B's books for the year ended 31 Dec 20x6.
Dr Cash
12,500,000
Dr Unamortized discount on debt
553,331
Cr Debt
12,000,000
Cr Equity Options
1,053,331
13,053,331
13,053,331
Dr Interest expense
Cr Cash
Cr Unamortized discount
171,700
120,000
51,700
(4) 50% of the MRCPS is converted on 31 Dec 20x8
Dr Equity options (50% * 1,053,331)
Dr Debt
Cr Unamortized discount on debt
Cr Issued share capital
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526,666
6,000,000
143,480
6,383,186
(includes rounding up)
Advanced Financial Accounting
Chapter 9 solutions
Problem 9.7
(1)
Allocate carrying value of bond to debt and equity components
PV of 10 payments of $200,000 @4%= $1,622,179
PV of $10,000,000 at end of 20x5
=
6,755,642
PV of liability component
(W1)
8,377,821
Equity component
1,622,179
= Proceeds
$10,000,000
Fair value of debt component at 1.1.20x3:
PV of 10 payments of $200,000 @ 3%=
$1,083,438
PV of principal at maturity
=
$8,374,843
$9,458,281
Repurchase price
$12,500,000
Amount allocated to equity component $3,041,719
The repurchase price is allocated as follows:
Carrying
Fair
Value
Value
Difference
Liability component:
Present value of 6 remaining half-yearly
interest payments of $200,000,discounted at
4% and 3%, respectively
1,048,427
1,083,438
Present value of $10,000,000 due
in 3 years, discounted at 4% and 3%,
half-yearly, respectively
7,903,145
8,374,843
8,951,572
9,458,281
506,709
Equity component
1,622,179
3,041,719*
1,419,540
Total
10,573,751
12,500,000
1,926,249
* This amount represents the difference between the fair value amount allocated to the liability component and
the repurchase price of $12,500,000.
(2)
Journal entries 1/1/20x1
Dr
Dr
Cr
Cr
31/12/20x1
Dr
Dr
Cr
Cr
Cash
Unamortized bond discount
Bond payable
Capital reserve - Equity
10,000,000
1,622,179
10,000,000
1,622,179
Interest expense
200,000
Amortization of bond discount 140,517
Cash
Unamortized bond discount
1/1/20x1
30/6/20x1
31/12/20x1
200,000
140,517
Cash
interest
Effective
interest
Amortization
expense
200,000
200,000
335,113
340,517
135,113
140,517
Carrying value
of bond
8,377,821
8,512,934
8,653,451
1/1/20x3
Dr
Dr
Bond payable
Debt settlement expense (P/L)
10,000,000
506,708
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Cr
Cash
Cr
Unamortized discount on bond
(To recognise the repurchase of the liability component.)
9,458,281
1,048,427
Dr Equity
3,041,719
Cr Cash
3,041,719
(To recognise the cash paid for the equity component.)
The equity component remains as equity, but may be transferred from one line item within
equity to another.
Problem 9.8
(1)
Journal entries
1 July 20x1
Dr
Held-to-maturity security (Bond A)
102,673
Dr
Held-to-maturity security (Bond B)
100,000
Cr
Cash
202,673
(Record purchase of bonds classified as held-to-maturity (HTM)).
30 June 20x2
Dr
Cash
Cr
Interest income – Bond A
Cr
Interest income - Bond B
(Record cash interest income on bonds)
12,000
7,000
5,000
Dr
Interest income
840
Cr
Held-to-maturity – Bond A
(Amortization of bond premium: see table below)
Date
840
Amortisation
Unamortized
Carrying
Coupon
Effective
of bond
bond
Value of
interest
interest
Premium
premium
Bond
01/07/20x1
2,673
102,673
30/06/20x2
7,000
6,160
840
1,833
101,833
30/06/20x3
7,000
6,110
890
943
100,943
30/06/20x4
7,000
6,057
943
0
100,000
Journal entries to record sale of Bond A on 30 June 20x2.
Dr
Cash
103,719
Cr
Bond
101,833
Cr
Gain on sale of bond
1,886
(Record sale of Bond A and gain on bond).
Note: The sale of Bond A 2 years ahead of its maturity date taints the remaining bond
(Bond B) which has been classified as held-to-maturity. IAS 39 requires that Bond be
reclassified as available-for-sale for at least 2 years.
Dr
Available for sale security (at fair value) 101,794
Cr
Held-to-maturity investment
100,000
Cr
Fair value reserve (equity)
1,794
[Reclassification of Bond B from HTM to AFS as a result of ‘tainting’]
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Problem 9.9
31 October 20x4
Dr Investment (AFS)
10,000
Cr Cash
10,000
(Record purchase of available-for-sale investments)
31 December 20x4
Dr
Fair value reserves – equity
1,000
Cr
Investments (AFS)
1,000
(Fair value adjustment to AFS and change in fair value taken to equity).
Note: As at 31 December 20x4, there was no objective evidence of impairment of the AFS
notwithstanding that the fair value has declined.
30 June 20x5
Dr
Impairment loss
9,000
Cr
Fair value reserve – equity
1,000
Cr
Investments (AFS)
8,000
(Record impairment loss on AFS in accordance with the provisions of IAS 39. There was objective
evidence of impairment. The impairment loss together with the deferred loss taken to equity are recognised
in income immediately.)
Problem 9.10
(1)
Carrying amount of note
Fair value of revised note:
PV of interest receivable in 20x3
PV of interest receivable in 20x4
PV of principal of $500,000
PV of future cash flows from note
Impairment loss
$800,000
$23,148
$21,433
$428,669
473,251
($326,749)
(2)
Adjusting journal entries
1 January 20x3
Dr
Interest income
64,000
Cr
Interest receivable
64,000
(Write off interest receivable for 20x2)
Dr
Impairment loss
326,749
Cr
Note receivable
326,749
(Record impairment loss on note receivable)
31 December 20x3
Dr
Dr
Cash
Note receivable
25,000
12,860
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Cr
Interest income
37,860
(Record interest income at effective interest rate of 8% for 20x3:
Effective interest income = 0.08 * $473,251 = $37,860)
31 December 20x4
Dr
Cash
Dr
Note receivable
Cr
Interest income
25,000
13,889
38,889
(Record interest income at effective interest rate of 8% for 20x4:
Effective interest income = 0.08 * $486,111 = $38,889)
Dr
Cash
500,000
Cr
Note receivable
500,000
(Record repayment of reduced principal of $500,000)
Problem 9.11
(1) Present value of coupon + principal = 39,000*5.7955 + 2,600,000*0.9420 =
2,675,255
Amortization table (in USD)
Date
Coupon
Effective
Amortized
Unamortized
interest
interest
interest
Premium
1 Jan 2010
75,255
30 Jun 2010
39,000
26,752
12,248
63,007
31 Dec 2010
39,000
26,631
12,369
50,638
30 Jun 2011
39,000
26,507
12,493
38,145
31 Dec 2011
39,000
26,382
12,618
25,527
30 Jun 2012
39,000
26,256
12,744
12,783
31 Dec 2012
39,000
26,128
12,872
-89
(Balance because effective interest rate is up to 4 decimal places only)
Entries in A’s book in SGD
1 Jan 2010 Purchase of convertible bonds
Dr Investment in Debt Security (2,600,000*1.4)
Dr Unamortized premium (75,255*1.4)
Dr Equity Options purchased (324,745*1.4)
Cr Cash (3,000,000*1.4)
30 Jun 2010 Coupon interest settlement
Dr Cash (39,000*1.38)
Dr Exchange loss
Cr Interest income (26,752*1.39)
Cr Unamortized premium (12,248*1.39)
31 Dec 2010 Coupon interest settlement
Dr Cash (39,000*1.32)
Dr Exchange loss
Cr Interest income (26,631*1.34)
Cr Unamortized premium (12,369*1.34)
Exchange loss on debt carrying amount
Dr Exchange loss
Cr Investment in Debt Security
3,640,000
105,357
454,643
4,200,000
53,820
390
37,185
17,025
51,480
780
35,686
16,574
212,916
Debt carrying amount in SGD, at 31 Dec 2010 rate (2,650,638*1.32)
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212,916
3,498,842
Carrying
amount
2,675,255
2,663,007
2,650,638
2,638,145
2,625,527
2,612,783
2,600,000
Advanced Financial Accounting
Chapter 9 solutions
Debt carrying amount in SGD, at actual rate
(3,745,357 – 17,025 – 16,574)
Exchange loss
Dr Exchange loss
Cr Equity options purchased
3,711,758
(212,916)
25,840
25,840
FV of equity option remains unchanged, but now translated on 31 Dec 2010.
Equity option on 1 Jan 2010
454,503
Equity option on 31 Dec 2010 (324,745*1.32)
428,663
Exchange loss
25,840
30 Jun 2011 Coupon interest settlement
Dr Cash (39,000*1.2)
Dr Exchange loss
Cr Interest income (26,507*1.25)
Cr Unamortized premium (12,493*1.25)
31 Dec 2011 Coupon interest settlement
Dr Cash (39,000*1.3)
Cr Exchange gain
Cr Interest income (26,128*1.24)
Cr Unamortized premium (12,872*1.24)
Exchange loss on debt carrying amount
Dr Exchange loss
Cr Investment in Debt Security
46,800
1,950
33,134
15,616
50,700
2,340
32,399
15,961
54,081
54,081
Debt carrying amount in SGD, at 31 Dec 2011 rate (2,625,527*1.3)
3,413,185
Debt carrying amount in SGD, at actual rate (3,498,843 – 15,616 – 15,961)3,467,266
Exchange loss
54,081
Exchange loss on equity option
Dr Exchange loss
Cr Equity option purchased
6,494
6,494
FV of equity option remains unchanged, but now translated on 31 Dec 2011.
Equity option on 31 Dec 2010
428,663
Equity option on 31 Dec 2011 (324,745*1.3)
422,169
Exchange loss
(6,494)
Analytical check of total P/L (in S$):
Beginning balance: 3,745,357
Final balance: 3,413,185
Difference: 332,172
Exchange loss = 54,081 + 212,916 = 266,997
Amortization = 17,025 + 16,574 + 15,616 + 15,961 = 65,176
Total loss = 332,173
(2)
K’s book
1 Jan 2010 Purchase of convertible bonds
Dr Cash
3,000,000
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Cr Bond issued
Cr Unamortized premium
Cr Capital reserve – Equity options
2,600,000
75,255
324,745
30 Jun 2010 Coupon interest settlement
Dr Interest expense
Dr Unamortized premium
Cr Cash
26,752
12,248
31 Dec 2010 Coupon interest settlement
Dr Interest expense
Dr Unamortized premium
Cr Cash
26,631
12,369
30 Jun 2011 Coupon interest settlement
Dr Interest expense
Dr Unamortized premium
Cr Cash
26,507
12,493
31 Dec 2011 Coupon interest settlement
Dr Interest expense
Dr Unamortized premium
Cr Cash
26,128
12,872
39,000
39,000
39,000
39,000
(3)(a)
A’s book (no conversion to equity)
30 June 2012 Coupon interest settlement
Dr Cash (39,000*1.28)
Dr Exchange loss
Cr Interest income (26,255*1.29)
Cr Unamortized premium (12,745*1.29)
49,920
390
Exchange gain on debt carrying amount
Dr Investment in Debt Security
Cr Exchange gain
52,258
33,869
16,441
52,258
Debt carrying amount in SGD, at 30 June 2012 rate (2,612,880*1.28)
Debt carrying amount in SGD, at actual rate (3,413,185 – 16,441)
Exchange gain
3,344,486
3,396,744
52,258
Recognition of impairment loss
Dr Impairment loss
Cr Investment in Debt Security
3,318,186
3,318,186
Unadjusted debt carrying amount in SGD, at 31 Dec 2012 rate
(2,612,880*1.28)
Debt FV at 31 Dec 2012 (20,000*1.28)
Impairment loss in SGD
3,344,486
25,600
(3,318,186)
(b)
A’s book (conversion to equity)
Same as (a), in addition assume fair value of equity securities is the same as fair value
of debt security and equity option purchased
Dr Investment in equity security
441,274
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Cr Investment in debt security
Cr Equity Options purchased (324,745*1.28)
25,600
415,674
Problem 9.12
(1)
Entries in A’s book in SGD
1 Jan 2010 Purchase of convertible bonds
Dr FVOCI Debt Security (2,675,255*1.4)
Dr Equity Options purchased (324,745*1.4)
Cr Cash (3,000,000*1.4)
30 Jun 2010 Coupon interest settlement
Dr Cash (39,000*1.38)
Dr Exchange loss
Cr Interest income (26,752*1.39)
Cr FVOCI Debt Security (12,248*1.39)
31 Dec 2010 Coupon interest settlement
Dr Cash (39,000*1.32)
Dr Exchange loss
Cr Interest income (26,631*1.34)
Cr FVOCI Debt Security (12,369*1.34)
Exchange loss on debt carrying amount
Dr Exchange loss
Cr FVOCI Debt Security
3,745,357
454,643
4,200,000
53,820
390
37,185
17,025
51,480
780
35,686
16,574
212,916
212,916
FVOCI carrying amount in SGD, at 31 Dec 2010 rate (2,650,638*1.32) 3,498,842
FVOCI carrying amount in SGD, at actual rate
(3,745,357 – 17,025 – 16,574)
3,711,758
Exchange loss
(212,916)
Recognition of FV change in OCI
Dr Deferred loss (OCI)
Cr FVOCI Debt Security
198,842
198,842
Debt carrying amount in USD, at 31 Dec 2010 rate (2,650,638*1.32)
Debt FV at 31 Dec 2010 (2,500,000*1.32)
Deferred loss in SGD
3,498,842
3,300,000
198,842
Dr Exchange loss
Cr Equity options purchased
25,840
25,840
FV of equity option remains unchanged, but now translated on 31 Dec 2010.
Equity option on 1 Jan 2010
454,503
Equity option on 31 Dec 2010 (324,745*1.32)
428,663
Exchange loss
25,840
30 Jun 2011 Coupon interest settlement
Dr Cash (39,000*1.2)
Dr Exchange loss
Cr Interest income (26,507*1.25)
Cr FVOCI Debt Security (12,493*1.25)
46,800
1,950
33,134
15,616
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31 Dec 2011 Coupon interest settlement
Dr Cash (39,000*1.3)
Cr Exchange gain
Cr Interest income (26,128*1.24)
Cr FVOCI Debt Security (12,872*1.24)
50,700
2,340
32,399
15,961
Exchange loss on debt carrying amount
Dr Exchange loss
Cr FVOCI Debt Security
54,081
54,081
Debt carrying amount in SGD, at 31 Dec 2011 rate (2,625,527*1.3)
3,413,185
Debt carrying amount in SGD, at actual rate (3,498,843 – 15,616 – 15,961)3,467,266
Exchange loss
54,081
Recognition of FV change in OCI
Dr Deferred loss (OCI)
Cr FVOCI Debt Security
549,342
549,342
Debt carrying amount in SGD, at 31 Dec 2011 rate
(3,300,000 – 15,616 – 15,961 – 54,081)
Debt FV at 31 Dec 2011 (2,050,000*1.3)
Deferred loss in SGD
3,214,342
2,665,000
549,342
Exchange loss on equity option
Dr Exchange loss
Cr Equity option purchased
6,494
6,494
FV of equity option remains unchanged, but now translated on 31 Dec 2011.
Equity option on 31 Dec 2010
428,663
Equity option on 31 Dec 2011 (324,745*1.3)
422,169
Exchange loss
(6,494)
Analytical check of total P/L (in S$):
Beginning balance: 3,745,357
Final balance: 2,665,000
Difference: 1,080,357
Deferred loss = 549,342 + 198,842 = 748,184
Exchange loss = 54,081 + 212,916 = 266,997
Amortization = 17,025 + 16,574 + 15,616 + 15,961 = 65,176
Total loss = 1,080,321
(3)(a)
A’s book (no conversion to equity)
30 June 2012 Coupon interest settlement
Dr Cash (39,000*1.28)
Dr Exchange loss
Cr Interest income (26,255*1.29)
Cr FVOCI Debt Security (12,745*1.29)
49,920
390
Exchange loss on debt carrying amount
Dr FVOCI Debt Security
Cr Exchange loss
53,766
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33,869
16,441
53,766
Advanced Financial Accounting
Chapter 9 solutions
Debt carrying amount in SGD, at 30 June 2012 rate (2,612,880*1.28)
Debt carrying amount in SGD, at actual rate (3,414,693 – 16,441)
Exchange gain
Reclassification of deferred loss
Dr Impairment loss
Cr Deferred loss (OCI)
Recognition of impairment loss
Dr Impairment loss
Cr FVOCI Debt Security
3,344,486
3,398,252
53,766
748,312
748,312
2,676,225
2,676,225
Unadjusted debt carrying amount in SGD, at 31 Dec 2012 rate
(2,665,000 – 16,441+ 53,766)
Debt FV at 31 Dec 2012 (20,000*1.28)
Impairment loss in SGD
2,702,325
25,600
(2,676,725)
(b)
A’s book (conversion to equity)
Same as (a), in addition assume fair value of equity securities is the same as fair value of debt security
and equity option purchased
Dr Investment in equity security
480,243
Cr Investment in debt security
25,600
Cr Equity Options purchased (324,745*1.4)
454,643
Problem 9.13
(1)
Entries in A’s book in SGD
1 Jan 2010 Purchase of convertible bonds
Dr Trading Debt Security (2,675,255*1.4)
Dr Equity Options purchased (324,745*1.4)
Cr Cash (3,000,000*1.4)
30 Jun 2010 Coupon interest settlement
Dr Cash (39,000*1.38)
Dr Exchange loss
Cr Interest income (26,752*1.39)
Cr Trading Debt Security (12,248*1.39)
31 Dec 2010 Coupon interest settlement
Dr Cash (39,000*1.32)
Dr Exchange loss
Cr Interest income (26,631*1.34)
Cr Trading Debt Security (12,369*1.34)
Exchange loss on debt carrying amount
Dr Exchange loss
Cr Trading Debt Security
3,745,357
454,643
4,200,000
53,820
390
37,185
17,025
51,480
780
35,686
16,574
212,916
212,916
Debt carrying amount in SGD, at 31 Dec 2010 rate (2,650,638*1.32)
Debt carrying amount in SGD, at actual rate
(3,745,357 – 17,025 – 16,574)
Exchange loss
3,498,842
3,711,758
(212,916)
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Recognition of FV change in P/L
Dr Fair value gain/loss - trading debt
Cr Trading Debt Security
198,842
198,842
Debt carrying amount in USD, at 31 Dec 2010 rate (2,650,638*1.32)
Debt FV at 31 Dec 2010 (2,500,000*1.32)
Fair value loss in SGD
3,498,842
3,300,000
198,842
Dr Exchange loss
Cr Equity options purchased
25,840
25,840
FV of equity option remains unchanged, but now translated on 31 Dec 2010.
Equity option on 1 Jan 2010
454,503
Equity option on 31 Dec 2010 (324,745*1.32)
428,663
Exchange loss
25,840
30 Jun 2011 Coupon interest settlement
Dr Cash (39,000*1.2)
Dr Exchange loss
Cr Interest income (26,507*1.25)
Cr Trading Debt Security (12,493*1.25)
31 Dec 2011 Coupon interest settlement
Dr Cash (39,000*1.3)
Cr Exchange gain
Cr Interest income (26,128*1.24)
Cr Trading Debt Security (12,872*1.24)
Exchange loss on debt carrying amount
Dr Exchange loss
Cr Trading Debt Security
46,800
1,950
33,134
15,616
50,700
2,340
32,399
15,961
54,081
54,081
Debt carrying amount in SGD, at 31 Dec 2011 rate (2,625,527*1.3)
3,413,185
Debt carrying amount in SGD, at actual rate (3,498,843 – 15,616 – 15,961)3,467,266
Exchange loss
54,081
Recognition of FV change in P/L
Dr Fair value gain/loss - trading debt
Cr Trading Debt Security
549,342
549,342
Debt carrying amount in SGD, at 31 Dec 2011 rate
(3,300,000 – 15,616 – 15,961 – 54,081)
Debt FV at 31 Dec 2011 (2,050,000*1.3)
Fair value loss in SGD
Exchange loss on equity option
Dr Exchange loss
Cr Equity option purchased
3,214,342
2,665,000
549,342
6,494
6,494
FV of equity option remains unchanged, but now translated on 31 Dec 2011.
Equity option on 31 Dec 2010
428,663
Equity option on 31 Dec 2011 (324,745*1.3)
422,169
Exchange loss
(6,494)
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Chapter 9 solutions
Analytical check of total P/L (in S$):
Beginning balance: 3,745,357
Final balance: 2,665,000
Difference: 1,080,357
Fair value loss = 549,342 + 198,842 = 748,184
Exchange loss = 54,081 + 212,916 = 266,997
Amortization = 17,025 + 16,574 + 15,616 + 15,961 = 65,176
Total loss = 1,080,321
(3)(a)
A’s book (no conversion to equity)
30 June 2012 Coupon interest settlement
Dr Cash (39,000*1.28)
Dr Exchange loss
Cr Interest income (26,255*1.29)
Cr Trading Debt Security (12,745*1.29)
49,920
390
Exchange loss on debt carrying amount
Dr Trading Debt Security
Cr Exchange loss
53,766
33,869
16,441
53,766
Debt carrying amount in SGD, at 30 June 2012 rate (2,612,880*1.28) 3,344,486
Debt carrying amount in SGD, at actual rate (3,414,693 – 16,441)
3,398,252
Exchange gain
53,766
Recognition of fair value loss
Dr Fair value gain/loss – trading debt
Cr Trading Debt Security
2,676,225
2,676,225
Unadjusted debt carrying amount in SGD, at 31 Dec 2012 rate
(2,665,000 – 16,441+ 53,766)
2,702,325
Debt FV at 31 Dec 2012 (20,000*1.28)
25,600
Fair value loss in SGD
(2,676,725)
(b)
A’s book (conversion to equity)
Same as (a), in addition assume fair value of equity securities is the same as fair value of debt
security and equity option purchased
Dr Investment in equity security
480,243
Cr Investment in debt security
25,600
Cr Equity Options purchased (324,745*1.4)
454,643
Problem 9.14
A’s book (reclassification from FVOCI to amortized cost)
1 Jan 2012
Reclassify accumulated deferred loss to investment in debt security
Dr Investment in debt security
Cr Deferred loss (OCI)
Reclassify unamortized premium of debt security
Dr Unamortized premium (25,527*1.3)
Cr Investment in debt security
748,312
748,312
33,185
33,185
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Chapter 9 solutions
Problem 9.15
A’s book (reclassification from FVTPL to amortized cost)
1 Jan 2012
Reclassify unamortized premium of debt security
Dr Unamortized premium (25,527*1.3)
Cr Investment in debt security
33,185
33,185
Problem 9.16
(1)
Loss rate at initial recognition = 90,000/2,000,000 = 4.5%
Loss rate at reporting date = 500,000/2,000,000 = 25%
Increase in expected credit loss = $500,000 - $90,000 = $410,000
(2)
Significant changes in external market indicators of credit risk for a particular financial
instrument or similar financial instrument with the same term. Changes in market indicators
of credit risk include: credit spread, credit default swap prices for borrower, credit ratings,
fair values versus amortized cost, changes in prices of borrower’s credit instrument,
significant changes in operating results of borrower.
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Accounting
An IFRS® Standards Approach, 3e
Pearl Tan, Chu Yeong Lim and Ee Wen Kuah
Solutions Manual
Chapter 10
Accounting for Derivatives and Hedge Accounting
Copyright © 2016 by McGraw-Hill Education (Asia)
Advanced Financial Accounting (Tan, Lim and Kuah)
Chapter 10 Solutions
CHAPTER 10
CONCEPT QUESTIONS
1
A forward contract is considered more risky from the perspective of the individual
parties to the contact as it entails counterparty risk, that is, the risk that the counterparty
will not honour the terms of the contract.
2
A holder (buyer) of a call option or put option has limited potential loss as his maximum
loss is the amount that he had paid for the option should the option expire at or out-ofthe-money. His potential gain could exceed his potential loss if the option expires inthe-money. On the other hand, an option writer (seller)’s position is the opposite. His
gain is limited to the amount of premium that he had received while his loss may be
potentially high.
3
The factors to consider include:
 The relative cost of using a forward contract and an option contract
 The counterparty risk involved.
 Whether the contract could be terminated within a very short time or prematurely.
 Whether the contract could be tailored to the specific needs of the counterparties
 Whether the party intending to enter the contract is willing to take a position on the
short-term price movements of the commodity.
4
In a fair value hedge, the hedged item is a recognized asset or liability or unrecognized
firm commitment which is exposed to changes in fair value which could affect reported
earnings. In a cash flow hedge, the hedged item is a recognized asset or liability or a
highly probable forecasted transaction which is exposed to variability in cash flows that
could affect reported earnings.
5
A hedge of the foreign currency risk of a firm commitment may be designated either as
a cash flow hedge or a fair value hedge. It could be designated as a cash flow hedge
because changes in the foreign exchange rate could affect the cash flows when the firm
commitment is fulfilled. It could be designated as a fair value hedge because the firm
commitment carries rights and obligations and the fair value of the rights and
obligations is affected by changes in the foreign exchange rate.
6
A swap entails counterparty risk and is settled at a future date. In this respect it is similar
to a forward contract. In fact, a sway is a series of linked forward contract.
7
A firm commitment entails a commitment to purchase or sell an asset at a fixed price at
a future date. When the price of the asset rises or falls, the value of the firm commitment
is affected. Hence a hedge of a firm commitment is designated as a fair value hedge. A
forecasted transaction, on the other hand, does not entail any right or obligation or
commitment to a fixed price. The transaction will be consummated at a future price (on
the date the transaction takes place). Should the price increase or decrease, the result is
a higher or lower cash outlay for the transaction. Hence the hedge of a forecasted
transaction is designated as a cash flow hedge.
8
A hedge of a net investment is accounted for in a way similar to a cash flow hedge. The
effective portion is taken to equity and the ineffective portion, if any, is taken to income.
Advanced Financial Accounting (Tan, Lim and Kuah)
Chapter 10 Solutions
EXERCISES
Exercise 10.1
The answer is (b). The put option is in-the-money at the maturity date and the option premium
is entirely made up of the intrinsic value which is the exercise price less the market price ($3.60
- $3.55).
Exercise 10.2
The answer is (d).
Premium received on written put option
Less loss on intrinsic value
Net gain on put option
$1,800
(500)
$1,300
Exercise 10.3
The answer is (a). Changes in the fair value of a put option which is a fair value hedge are taken
to profit or loss, not to equity.
Exercise 10.4
The answer is (c).
Change in fair value of AFS taken to equity:
From 1 January to 1 July 20x5
From 1 October to 31 December 20x5
$70,000
($10,000)
$60,000
Exercise 10.5
The answer is (b). The swap is a cash flow hedge.
Exercise 10.6
The answer is (c) . The long put option position with a strike price of $3.00 ensures that the
option holder will gain if the price of the stock falls below $3.00. The gain will exactly offset
the loss on the price of the stock below $3.00 The short position on the call option with a strike
price of $4.00 means that if the price of the stock rises above $4.00 there will be a loss on the
call option which cancels out the gain on the stock when the price rises above $4.00.
Exercise 10.7
The answer is (c).
From 1/10/20x4 to 31/12/20x4
Change in fair value of firm commitment
[FC10,000,000 x (1.23 – 1.32)]
Change in fair value of forward contract
[FC10,000,000 x (1.33 – 1.25)
Net gain(loss)
($900,000)
$800,000
($100,000)
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Chapter 10 Solutions
Note: It is assumed that the forward contract is a fair value hedge of a firm commitment.
Exercise 10.8
The answer is (d).
Cost of equipment at spot rate on 1 February 20x5 $12,800,000
Less: Carrying value of firm commitment
(500,000)
Adjusted cost of equipment
$12,300,000
Exercise 10.9
The answer is (a).
Fair value of forward contract at maturity = FC10,000,000 x (!.28 – 1.25) = $300,000.
Exercise 10.10
The answer is (b).
If the call option is purchased for trading or speculation purpose, the change in the fair value
of the call option (comprising the time and intrinsic values) are taken to income under IAS 39.
Exercise 10.11
The answer is (c).
This is a fair value hedge. Gain or loss on the option is taken to income.
Gain on the option = gain on intrinsic value less loss on time value.
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Chapter 10 Solutions
PROBLEMS
Problem 10.1
(1) Assessment of hedge effectiveness
Change in value of
inventory based on spot
price of gold
Change in fair value of
futures contract
Date
Delta ratio
31-Dec-20x5 ($940 - $950) x 10,000 ($941 - $952) x 10,000 110,000
ounces = -$100,000
ounces = $110,000*
100,00
= 1.1
31-Jan-20x6 ($960 - $940) x 10,000 ($960 - $941) x 10,000 190,000
ounces = $200,000
ounces =
200,000
-$190,000*
= 0.95
* Since the futures contract is a short position, there is a gain when the current price is less than
the contracted price and vice versa. The hedge effectiveness is assessed on a period-to-period
basis. If it is assessed on a cumulative basis, the delta ratio will be as follows:
Delta ratio
At 31 December 20x5
1.1
At 31 January 20x6
0.80 (80,000/100,000)
The hedge is effective as the delta ratio is within the 0.8 and 1.25 range.
(2) Journal entries
1 November 20x5
Dr Margin deposit 330,000
Cr Cash
330,000
[To record payment of margin deposit on 100 contracts @ $3,300 per contract]
31 December 20x5
Dr Futures contract 110,000
Cr Gain on futures contract
110,000
[To record gain on futures contract]
Dr Loss on inventory
100,000
Cr Inventory
100,000
[To record change in fair value of inventory]
31 January 20x6
Dr Loss on futures contract 190,000
Cr Futures contract
[To record loss on futures contract]
190,000
5
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Chapter 10 Solutions
Dr Inventory
200,000
Cr Gain on inventory
[To record gain in fair value of inventory
200,000
Dr
Cash
250,000
Dr
Futures contract
80,000
Cr
Margin deposit
330,000
[Close futures position]
Note: In practice, the margin deposit requires topping up if it falls below a stipulated level. For
our purpose, the changes in the margin deposit (top-ups, if any) are ignored.
Problem 10.2
(1)
Notional amount
Spot price of oil
Strike price
Premium/unit
Fair value of option
Intrinsic value
Time value
31 Mar
30 April
31 May
100,000
$42
$40
$3
$300,000
$200,000
$100,000
100,000
$45
$40
$6
$600,000
$500,000
$100,000
100,000
$44
$40
$4
$400,000
$400,000
$0
(2) Journal entries
The option is a cash flow hedge. Since the time value of the option contract is excluded from
the hedge relationship and the critical terms match, the delta ratio is 1, that is, there is no
ineffective portion. It is assumed that discounting of the expected cash flow of the forecasted
transaction is ignored.
1 March 20x3
Dr
Call option
Cr
Cash
(Record purchase of call option)
200,000
200,000
31 March 20x3
Dr
Call option
200,000
Cr
Hedging reserves – equity
(Effective portion (intrinsic value) taken to equity)
Dr
Loss on time value
Cr
Call option
(Time value expensed to income)
100,000
3 April 20x3
Dr
Call option
300,000
Cr
Hedging reserves – equity
(Effective portion (intrinsic value) taken to equity)
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200,000
100,000
300,000
Advanced Financial Accounting (Tan, Lim and Kuah)
Chapter 10 Solutions
31 May 20x3
Dr
Hedging reserves – equity
100,000
Cr
Call option
(Effective portion (intrinsic value) taken to equity)
Dr
Loss on time value
Cr
Call option
(Time value expensed to income)
100,000
100,000
100,000
Dr
Purchase of jet fuel oil/inventory
Cr
Cash
(Purchase of jet fuel oil)
4,400,000
4,400,000
Dr
Hedging reserves – equity
400,000
Cr
Purchase of jet fuel oil/inventory
(Adjust effective portion of the hedge against cost of inventory)
400,000
Dr
Cash
Cr
Call option
( Close position on call option)
400,000
400,000
Problem 10.3
Journal entries for hedged item
Journal entries for hedging instrument
30.11.20x1
30.11.20x1
No journal entry is required to record the
firm commitment
Dr
Put option
Cr
Cash
500
[Purchase of put option]
30.6.20x2
30.6.20x2
Dr Loss on firm
Commitment (P/L)
500
Cr Firm commitment
500
[To record loss in fair value of firm
commitment]
500
Dr Put Option
500
Cr Gain on put option (P/L)
500
[Gain in intrinsic value of put option]
Dr Loss on put option (P/L)
300
Cr Put Option
300
[Loss on time value of put option]
7
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Chapter 10 Solutions
31.7.20x2
31.7.20x2
Dr Loss on firm
Commitment (P/L)
500
Cr Firm commitment
500
[To record loss in fair value of firm
commitment]
Dr Put option
500
Cr Gain on put option
500
[Gain in intrinsic value of put option]
Dr. Investment
5,000
Cr Cash
5,000
[Purchase of Fastrack shares for $5,000]
Dr Loss on put option 200
Cr Put option
200
[Loss in the time value of put option]
Dr. Firm commitment
1,000
Cr. Investment
1,000
[Transfer loss from firm commitment to
investment ]
Dr Cash
Cr Investment
(Sale of Fastrack shares).
Dr Cash
Cr Put option
(Close put option contract)
1,000
1,000
4,000
4,000
Problem 10.4
(1)
The premium on the put option on 28 February 20x4 is $0.07 per FC.
The fair value of put option, intrinsic value and time value are as follows:
Fair
Premium value
per FC
of option
Time
value
of option
01/03/20x3 500,000
0.045
22,500
22,500
01/06/20x3 500,000
0.055
27,500
17,500
10,000
31/12/20x3 500,000
0.06
30,000
5,000
25,000
28/02/20x4 500,000
0.07
35,000
Date
Notional
amount
Intrinsic
value
of option
-
-
35,000
As the critical terms match perfectly, and the time value of the put option is excluded from the
hedge relationship, the hedge is fully effective.
From 1 March 20x3 to 1 June 20x3, the hedged risk is the foreign exchange risk of a forecasted
transaction. Therefore it is a cash flow hedge. From 1 June to 31 December 20x3 the option is
a hedge of a firm commitment. However, IAS 39 allows the hedge to be designated as a cash
flow hedge or a fair value hedge. It is assumed that the hedge is redesignated as a fair value
hedge.
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(2) Journal entries
1 March 20x3
Dr
Put option
Cr
Cash/bank
(Purchase of put option)
22,500
22,500
1 June 20x3
Dr
Put option
5,000
Dr
Loss in time value
5,000
Cr
Hedging reserve – equity
10,000
(Record change in fair value of put option; change in intrinsic value is taken to equity
and change in time value is taken to profit or loss).
31 December 20x3
Dr
Put option
2,500
Cr
Gain on put option
2,500
(Record change in fair value of put option comprising gain in intrinsic value of $15,000
and loss in time value of -$12,500).
Dr
Cr
Loss on firm commitment
Firm commitment
Dr
Accounts receivable
Cr
Sales
(Record delivery of equipment)
15,000
15,000
850,000
850,000
Dr
Hedging reserve – equity
10,000
Dr
Firm commitment
15,000
Cr
Sales
25,000
(Adjust accumulated gain on option contract to sales)
28 February 20x4
Dr
Put option
5,000
Cr
Gain on put option
5,000
(Record change in fair value of put option comprising gain in intrinsic value of $10,000
and loss in time value of $5,000.)
Dr
Loss on account receivable 10,000
Cr
Accounts receivable
(Record exchange loss on accounts receivable)
10,000
Dr
Cash
840,000
Cr
Accounts receivable
(Record settlement of accounts receivable)
840,000
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Chapter 10 Solutions
Dr
Cash
Cr
Put option
(Net settlement of put option)
35,000
35,000
Note: If the put option is designated as a cash flow hedge throughout the period, the net effect
is still the same. The journal entries on 31 December 20x3 would be as follows:
Dr
Put option
2,500
Dr
Loss in time value
12,500
Cr
Hedging reserve – equity
15,000
(Record change in fair value of put option; change in intrinsic value is taken to equity
and change in time value is taken to profit or loss).
Dr
Hedging reserve – equity
25,000
Cr
Sales
25,000
(Adjust accumulated gain on option contract to sales)
Other journal entries remain unchanged.
Problem 10.5
(1) Journal entries
1 October 20x4 (optional)
Dr
Investment (AFS)
358,400
Cr
Cash
(Purchase of available-for-sale investment)
358,400
1 November 20x4
Dr
Fair value reserves – equity
2,150
Cr
Investment (AFS)
2,150
(Record change in fair value of available-for-sale investment in equity:
Fair value of investment at 1 November 20x4 = LC2.85 x 100,000 x $1.25 = $356,250.)
31 December 20x4
Dr
Investment (AFS)
Dr
Forward contract
Dr
Exchange loss on investment
Cr
Fair value reserves – equity
Cr
Gain on forward contract
(Record change in fair value of investment
change in foreign exchange rate:
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6,750
11,400
12,000
18,750
11,400
attributable to change in stock price and
Advanced Financial Accounting (Tan, Lim and Kuah)
Chapter 10 Solutions
Fair value of investment at 1/11/20x4
Fair value of investment at 31/12/20x4
Change in fair value
Attributable to:
Change in share price only*
[100,000 x 1.25 x ($3.00 – 2.85)
Change in foreign exchange rates
[100,000 x 3 x ($1.21 - $1.25)
$356,250
363,000
$6,750
$18,750
(12,000)
$ 6,750
Change in fair value of forward contract:
285,000 x (1.23 – 1.19)
=
$12,000
Note: The investment in Scotts Corporation is exposed to dual risk: price risk of Scotts’ shares
and foreign exchange risk. The change in fair value of the investment (including the portion
attributable to foreign exchange rate change) is taken to equity in accordance with IAS 39 if
the investment is not hedged. If the investment is hedged against foreign exchange risk, only
the change in fair value attributable to the hedged risk (the foreign exchange rate risk) is taken
to income. The change in the fair value of the investment attributable to the change in the
market price of the shares is derived by holding the exchange rate constant (assuming no
change in exchange rate).
Dr
Put option
3,630
Cr
Cash
3,630
(Purchase of put option: 100,000 x 0.03 x 1.21)
31 March 20x5
Dr
Fair value reserves – equity
8,470 * reversed out to I/S see last entry
Dr
Exchange loss on investment
2,930
Dr
Loss on forward contract
2,850
Cr
Investment (AFS)
11,400
Cr
Forward contract
2,850
(Record change in fair value of investment attributable to change in stock price and change
in foreign exchange rate:
Fair value of investment at 31/12/20x4
Fair value of investment at 31/03/20x5
Change in fair value
Attributable to:
Change in share price
[100,000 x 1.21 x ($2.93 – 3.0)
Change in foreign exchange rates
[100,000 x 2.93 x ($1.20 - $1.21)
$ 363,000
$ 351,600
($11,400)
($8,470)
($2,930)
($ 11,400)
Change in fair value of forward contract:
285,000 x (1.21 – 1.20)
Dr
Cr
Cash
Forward contract
=
$2,850
8,550
8,550
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(Settle forward contract at maturity date on a net basis)
Dr
Put option
6,570
Cr
Gain on put option
6,570
(Gain on put option: [(100,000 x 0.085 x 1.2) - $$3,630])
Note: Since both the time value and intrinsic value are taken to income, it is not
necessary to split the change in the fair value of the option into these two components.)
Dr
Loss on investment (AFS)
8,470
Cr
Fair value reserve – equity
8,470
(Change in fair value of AFS attributable to change in the share price transferred from
equity to income).
Note: From 31 December 20x4, the price risk of the investment (AFS) is hedged; the
change in fair value attributable to the change in share price is taken to income together
with the change in the fair value of the hedging instrument. This journal entry can be
combined with; however, for clarity purpose, it is split into separate journal entries.
30 June 20x5
Dr
Put option
7,950
Cr
Gain on put option
(Record change in fair value of put option in income)
7,950
Dr
Loss on investment (AFS)
9,600
Cr
Investment (AFS)
9,600
(Record change in fair value of investment attributable to price change)
Dr
Investment (AFS)
2,850
Cr
Fair value reserves – equity
2,850
(Change in fair value of investment attributable to change in the rate of foreign
exchange taken to equity: 100,000 x 2.85 x (1.21 – 1.20) = $2,850
Dr
Cash
Cr
Put option
(Close position on put option)
18,150
Dr
Cash
344,850
Cr
Investment
available-for-sale investment: 100,000 x 2.85 x 1.21)
18,150
344,850
Dr
Fair value reserves (equity)
19,450
Cr
Gain on hedging
19,450
(Transfer cumulative fair value adjustments from equity to income).
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(Liquidate
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Chapter 10 Solutions
Summary:
Investment at cost
Sale proceeds
Loss on investment
$358,400
344,850
($13,550)
Allocated to:
Equity
Income
19,450
(33,000)
Allocated to:
Equity
Change in FV of AFS
Income
01/11/20x4
(2,150)
(2,150)
31/12/20x4
6,750
18,750
(12,000)
31/03/20x5
(11,400)
(8,470)
(2,930)
8,470
(8,470)
(6,750)
2,850
(9,600)
(13,550)
19,450
Transfer
30/06/20x5
(33,000)
Problem 10.6
Note: This question has two components: a forecasted transaction and a firm commitment. The
fair value hedge is applicable only from 1 February to 30 March 20x2. For the period 1
December 20x1 to 1 February 20x2 there is a forecasted transaction. The forward contract is
required to be designated as a cash flow hedge. From 1 February 20x2 to 30 March 20x2, the
forecasted transaction became a firm commitment and may be designated either as a cash flow
hedge or a fair value hedge. Consequently, it is assumed that it is redesignated as a fair value
hedge .
Calculation of changes in fair value of forward contract and its components
Notional
Date
Amount
Current
spot
rate
Contracted
Fwd rate
Current
Fwd
rate
FC000
FV
Fwd
of
contract
Change
in
FV
of
Fwd
Change in
spot
element
Change
in
time
value
$000
$000
$000
$000
01/12/x1
10,000
1.74
1.7
31/12/x1
10,000
1.7
1.7
1.67
300
300
400
(100)
01/02/x2
10,000
1.65
1.7
1.63
700
400
500
(100)
30/03/x2
10,000
1.69
1.7
1.69
100
(600)
(400)
(200)
Calculation of change in expected cash flows
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Notional
Amount
Current
Date
FC000
spot rate
Expected
Cashflow
($000)
Change in
Expected CF
($000)
01/12/x1
10,000
1.74
17,400
31/12/x1
10,000
1.7
17,000
(400)
01/02/20x2
10,000
1.65
16,500
500
30/03/20x2
10,000
1.69
16,900
400
The hedge is effective as the critical terms match and the time value of the forward contract is
excluded from the hedging relationship.
Journal entries:
1 December 20x1
No journal entry is required as the fair value of
The forward contract is nil.
31 December 20x2
Dr
Forward contract
300,000
Dr
Loss in time value
100,000
Cr
Hedging reserve – equity
400,000
(Record:
 change in fair value of forward contract
 expense off time value (interest component) to income
 defer effective portion (spot component) to equity.
Note: As the critical terms match exactly and the time value component is excluded
from the hedge relationship, there is no ineffective portion in the hedge. The time value
(interest component is taken to profit or loss).
1 February 20x2
Dr
Forward contract
400,000
Dr
Loss in time value
100,000
Cr
Hedging reserve – equity
500,000
(Record:
 change in fair value of forward contract
 expense off time value (interest component) to income
 defer effective portion (spot component) to equity)
30 March 20x2
Dr
Loss on forward contract
600,000
Cr
Forward contract
600,000
(Record change in fair value of forward contract. There is no need to split the change
in fair value into its spot and time value components since both are taken to profit or
loss).
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Dr
Firm commitment
400,000
Cr
Gain on firm commitment
(Record change in fair value of firm commitment)
Dr
Cr
Cash
16,900,000
Sales
(Record recognition of sales revenue)
400,000
16,900,000
Dr
Hedging reserve
900,000
Cr
Firm commitment
400,000
Cr
Sales
500,000
(Transfer/adjust effective portion of cash flow hedge and firm commitment against
sales revenue).
Dr
Cash
100,000
Cr
Forward contract
(Settlement of forward contract on a net basis).
100,000
Problem 10.7
The forward contract is designated as a cash flow hedge for the entire period 1 December 20x1
to 30 March 20x2. The journal entries from 1 December 20x1 to 1 February 20x2 are the same
as in P 9.6.
30 March 20x2
Dr
Hedging reserve
400,000
Dr
Time value (Interest component) (I/S) 200,000
Cr
Forward contract
600,000
(Record:
 change in fair value of forward contract
 expense off time value (interest component) to income
 defer effective portion (spot component) to equity.)
Dr
Cash
Cr
Sales
(Record recognition of sales revenue)
16,900,000
16,900,000
Dr
Hedging reserve
500,000
Cr
Sales
500,000
(Transfer/adjust effective portion of cash flow hedge and firm commitment against
sales revenue).
Dr
Cash
100,000
Cr
Forward contract
(Settlement of forward contract on a net basis).
100,000
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Chapter 10 Solutions
Problem 10.8
The hedged risk is the foreign exchange risk of a firm commitment. IAS 39 permits the forward
contract to be designated either as a cash flow hedge or a fair value hedge. This question
requires the forward contract to be designated as a fair value hedge.
The calculations of the fair value of the forward contract and changes in the fair value and its
components are as follow:
Contract
Fwd rate
Current
Fwd
rate
Notional
Amount
2.98
2.98
$0
2.937
2.98
2.969
100,000
31.1.20x6
2.92
2.98
2.9269
31.3.20x6
2.931
2.98
2.931
Date
Spot
Rate
30.9.20x5
2.915
31.12.20x5
Fair value of
fwd
contract
Change in fair
value of
fwd. contract
$0
$0
1.0150751*
(1,084)
(1,084)
100,000
1.010025
(5,257)
(4,174)
100,000
1
(4,900)
357
Discount
Factor
*(1.06)^3/12
Date
Cum.
Change
Period to
in spot
period change in
element
spot element
Period to period
Period to period
Cum. Change in
change in
change in fair value
interest element
interest element
of fwd contract
(a)
(b)
c = (a) + (b)
30.9.20x5
31.12.20x5
2,167
2,167
(3,251)
(3,251)
(1,084)
31.1.20x6
495
(1,672)
(5,752)
(2,501)
(4,174)
31.3.20x6
1,600
1,105
(6,500)
(748)
357
(1) Time value (interest element is excluded from the hedge relationship)
Hedge relationship is designated as:
Change in fair value of forward contract based on spot rate
Change in fair value of forward commitment (based on spot rate)
Since both the hedged item and the hedging instrument are based on spot rates and the critical
terms match, the hedge is fully effective.
Journal entries:
30 September 20x5
No journal entry required.
31 December 20x5
Dr
Interest element (I/S)
3,251
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Cr
Hedging reserve – equity
2,167
Cr
Forward contract
1,084
(To record change in fair value of forward contract; effective portion (spot element) taken to
equity and interest element taken to income.)
31 January 20x6
Dr
Interest element (I/S)
2,502*
Dr
Hedging reserve – equity
1,672
Cr
Forward contract
4,174
(To record change in fair value of forward contract; effective portion (spot element) taken to
equity and interest element taken to income.)
*includes rounding difference of 1
Dr
Inventory
292,000
Dr
Hedging reserve
495
Cr
Inventory
495
Cr
Accounts payable
292,000
(To record purchase of inventory at spot rate and adjust the cumulative effective portion of the
forward contract to the cost of inventory.)
31 March 20x6
Dr
Accounts payable
292,000
Dr
Exchange loss on payable
1,100
Cr
Cash
293,100
(To record settlement of accounts payable and exchange loss on the payable)
Dr
Forward contract
357
Cr
Gain on forward contract
(To record change in fair value of forward contract)
357
Dr
Forward contract
4,900
Cr
Cash
4,900
(To record settlement of the forward contract on a net basis).
(2) Time value (interest element was not excluded from hedge relationship)
The hedging relationship is expressed as:
Change in fair value of forward contract based on forward rate
Change in fair value of forward commitment (based on forward rate)
As both the hedged item and the hedging instrument are based on the forward rate and the
critical terms match exactly, the hedge is fully effective.
Notional
Discount
Period to
period change
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Amount
FC000
Date
Current
Fwd
rate
Expected
Cashflow
Cum.
Change
in expected
cash flows
Factor
PV of
change
in expected
cash flows
in PV of
expected CF
30/09/20x5
100,000
2.98
298,000
-
31/12/20x5
100,000
2.969
296,900
-1,100
1.015075
(1,084)
(1,084)
31/01/20x6
100,000
2.9269
292,690
-5,310
1.010025
(5,257)
(4,174)
31/03/20x6
100,000
2.931
293,100
-4,900
1
(4,900)
357
Journal entries:
30 September 20x5
No journal entry required.
31 December 20x5
Dr
Hedging reserve -Equity
1,084
Cr
Forward contract
1,084
(To record the change in fair value of forward contract which is credited to equity. The
hedge is fully effective as the change in the fair value of the forward contract offsets
completely the present value of the change in expected cash flows).
31 January 20x5
Dr
Hedging reserve -Equity
4,174
Cr
Forward contract
4,174
(To record the change in fair value of forward contract directly to equity).
Dr
Inventory
292,000
Dr
Inventory
5,258*
Cr
Hedging reserve
5,258
Cr
Accounts payable
292,000
(To record purchase of inventory at spot rate and adjust the cumulative hedging reserve to the
cost of inventory.)
31 March 20x6
Dr
Accounts payable
292,000
Dr
Exchange loss on payable
1,100
Cr
Cash
293,100
(To record settlement of accounts payable and exchange loss on the payable)
Dr
Forward contract
357
Cr
Gain on forward contract
(To record change in fair value of forward contract)
357
Dr
Forward contract
4,900
Cr
Cash
4,900
(To record settlement of the forward contract on a net basis).
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Chapter 10 Solutions
Problem 10.9
The critical terms of the forward contract and the hedged item match and the time value element
is excluded from the hedge relationship. Therefore the hedge is fully effective. Discounting is
ignored.
The following shows the calculation of the fair value of the forward contract and changes in
the fair value of the forward contract and its components.
Change
in
FV
of
fwd
Change
in
Change in
spot
interest
Notional
Spot
Forward
Fair value
of
forward
amount
rate
rate
contract
contract
element
element
01/12/20x1
10,000,000
1.84
1.8
31/12/20x1
10,000,000
1.73
1.7
1,000,000
1,000,000
1,100,000
(100,000)
01/03/20x2
10,000,000
1.7
1.68
1,200,000
200,000
300,000
(100,000)
01/04/20x2
10,000,000
1.76
1.76
400,000
(800,000)
(600,000)
(200,000)
Forward contract is accounted for as a fair value hedge
Journal entries
1 December 20x1
No journal entry is necessary.
31 December 20x1
Dr
Forward contract
1,000,000
Cr
Gain on forward contract
1,00,000
(Record change in fair value of forward contact and gain on forward contract. There is
no need to separate the spot and interest components since both are taken to profit or
loss).
Dr
Loss on firm commitment
1,100,000
Cr
Firm commitment
1,100,000
(Record change in fair value of firm commitment based on spot rate)
1 March 20x2
Dr
Forward contract
200,000
Cr
Gain on forward contract
200,000
(Record change in fair value of forward contact and gain on forward contract.).
Dr
Loss on firm commitment
300,000
Cr
Firm commitment
300,000
(Record change in fair value of firm commitment based on spot rate)
Dr
Cr
Accounts receivable
Sales
17,000,000
17,000,000
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(Record delivery and sales)
Dr
Firm commitment
1,400,000
Cr
Sales
(Adjust firm commitment against sale)
1,400,000
1 April 20x2
Dr
Bank
17,600,000
Cr
Exchange gain
600,000
Cr
Accounts receivable
17,000,000
(Settlement of accounts receivable and record exchange gain on
accounts receivable)
Dr
Loss on forward contract
Cr
Forward contract
(Record loss on forward contract)
800,000
800,000
Dr
Cash
400,000
Cr
Forward contract
(Settlement of forward contract on a net basis)
400,000
Problem 10.10
(1) The entire forward contract is designated as the hedging instrument, that is, the interest
element (time value) is not excluded from the hedge relationship. To ensure that the criterion
of hedge effectiveness is met, the hedge relationship should be designated as:
Change in the fair value of the forward contract based on changes in the forward rate
Change in the present value of cash flow based on changes in the forward rate
The hedged risk is the foreign currency risk of a firm commitment. The firm commitment is a
contractual obligation to buy a certain quantity of paper for FC100,000. Should the FC
appreciate, there will be a loss on the firm commitment (compared to the date when the
commitment was entered into); conversely should the FC depreciate, there will be a gain on
the firm commitment. The discounted fair values of the forward contract and the expected cash
flows (based on the forward rates) are as follows:
Spot
Contract
Notional
Discount
Fwd rate
Current
Fwd
rate
Date
Rate
amount
Factor
30/6/x1
1.072
1.077
1.077
$0
Fair
value of
fwd.
contract
Change
in FV of
Spot
Interest
fwd
element
Element
-
-
-
-
485
485
776
(291)
(1.005)^6=
31/12/x1
1.08
1.077
1.082
100,000
1.0303775
31/3/x2
1.083
1.077
1.0845
100,000
1.0150751
739
254
308
(54)
30/6/x2
1.087
1.077
1.087
100,000
1
1,000
261
416
(155)
(1.005)^3=
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Cum.
Change
in expected
cash flows
Discount
Factor
PV of
change
in expected
cash flows
Period to
period
change
in PV of
expected CF
Date
Notional
Amount
FC000
Current
Fwd
rate
Expected
Cashflow
30/6/x1
100,000
1.077
107,700
31/12/x1
100,000
1.082
108,200
500
1.030378
485
485
31/3/x2
100,000
1.0845
108,450
750
1.015075
739
254
30/6/x2
100,000
1.087
108,700
1,000
1
1,000
261
-
The hedge is fully effective as numerator and denominator are based on same forward rates.
(1) Journal entries:
30/6/20x1
Dr
Cr
Forward contract
Cash
0
0
OR nil entry
[Fair value of forward contract at inception is zero as hedge is expected to be fully effective
because critical terms of forward exchange contract and purchase contract and the assessment
of hedge effectiveness are based on the forward price (Time value is not excluded).
31/12/20x1
Dr
Cr
Forward contract
Hedging reserve (equity)
485
485
[To record change in fair value of the forward exchange contract between 30 Jun 20x3 and 31
Dec 20x3 directly in equity (IAS39:95). The hedge is fully effective because the gain on the
forward exchange contract exactly offsets the change in cash flows associated with the
purchase contract based on the forward price.]
31/3/20x2
Dr
Cr
Forward contract
Hedging reserve
Dr
Cr
Inventory
Payable
Dr
Cr
Hedging reserves
Inventory
254
254
108,300
108,300
739
739
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[To recognize purchase of commodity at spot rate (1.083 x FC100,000] and remove cumulative
gain on forward exchange contract that has been recognized directly in equity and include it in
the initial measurement of purchased paper. Accordingly, initial measurement of purchased
commodity is $107,561 consisting of purchase consideration of $108,300 & hedging gain of
$739.]
30/6/20x2
Dr
Exchange loss
400
Dr
Payable
108,300
Cr
Cash
108,700
[To record exchange loss on payable ($1.087 – 1.083)*100k and settlement of the payable]
(2)
Dr
Cr
Forward contract
Gain on forward contract
261
Dr
Cr
Cash
Forward contract
1,000
261
1,000
Time value is excluded from the hedge relationship.
The hedge relationship is expressed as:
Change in the fair value of the forward contract based on changes in the spot rate
Change in the present value of cash flow based on changes in the spot rate
31/12/20x1
Dr
Loss (interest element)
Dr
Forward contract
Cr
Equity (spot element)
(Please refer table in part (1) above)
291
485
776
[To record change in fair value of forward exchange contract between 30 Jun 20x1 & 31 Dec
20x1 directly in equity (IAS39:95). Change in present value of spot settlement of forward
exchange contract is a gain of $776, which is directly recognized in equity (IAS 39:95a). The
change in interest element of forward exchange contract (residual change in fair value) is a loss
of $291, which is recognized in profit or loss (IAS 39:74 and IAS 39:55a).
31/3/20x2
Dr
Loss (interest element)
Dr
Forward contract
Cr
Equity (spot element)
(see table in part (a) above)
54
254
308
Dr
Inventory
108,300
Dr
Equity
1,084
Cr
Inventory (hedging gain)
1,084
Cr
Payable
108,300
[To recognize the purchase of paper at spot rate (1.083 x FC100,000] and to remove the
cumulative gain on spot element of the forward exchange contract that has been recognized
directly in equity and include it in the initial measurement of the purchased paper.]
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30/6/20x2
Dr
Exchange loss
400
Dr
Payable
108,300
Cr
Cash
108,700
[To record exchange loss on payable ($1.087 – 1.083)*100k and settlement of the payable]
Dr
Cr
Forward contract
Gain on forward contract
261
Dr
Cr
Cash
Forward contract
1,000
261
1,000
(3) If time value is not excluded, the time value is taken to equity (as the hedge is effective). If
time value is excluded, the interest component is taken to income. Carrying value of inventory
in this case is higher when time value is excluded.
B/S: Carrying value of inventory
Income Statement
Time value not excluded
$107,561
0
Time value is excluded
$107,216
(345)
Problem 10.11
The forward contract is designated as a fair value hedge of a firm commitment. Time value is
excluded from the hedge relationship.
Hedge effectiveness is calculated as:
Change in the fair value of the forward contract based on changes in the spot rate
Change in the present value of firm commitment based on changes in the spot rate
The fair value of the firm commitment is calculated as follows:
Spot
Notional
Discount
FV of firm
Change
in
Date
Rate
amount
factor
commitment
FV
30/6/x1
1.072
100,000
31/12/x1
1.08
100,000
1.0303775
776
776
31/3/x2
1.083
100,000
1.0150751
1,084
308
30/6/x2
1.987
100,000
1
1,500
416
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Change
in
FV of firm
commitment
(Period-to
period)
Change in FV
of
firm
commitment
(Cumulative)
31/12/x1
776
31/3/x2
30/6/x2
Date
Change in
FV of fwd
contract
(Period-to
period)
Change in FV
of fwd contract
(Cumulative)
776
776
776
1
308
1,084
308
1,084
1
416
1,500
416
1,500
1
Delta ratio
30/6/x1
(1) Journal entries
31/12/20x1
Dr
Cr
Loss on firm commitment
Firm commitment
776
Dr
Cr
Forward contract
Gain on forward contract
776
Dr
Cr
Interest portion
Forward contract
291
Dr
Cr
Loss on firm commitment
Firm commitment
308
Dr
Cr
Forward contract
Gain on forward contract
308
Dr
Cr
Interest portion
Forward contract
Dr
Cr
Dr
Cr
Inventory
Payable
Firm commitment
Inventory
776
776
291
31/3/20x2
308
308
54
54
108,300
108,300
1,084
1,084
30/6/20x2
Dr
Exchange loss
400
Dr
Payable
108,300
Cr
Cash
108,700
[To record exchange loss on payable ($1.087 – 1.083)*100k and settlement of the payable]
Dr
Cr
Forward contract
Gain on forward contract
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261
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Chapter 10 Solutions
Dr
Cr
Cash
Forward contract
1,000
1,000
(2)
Inventory @ 31/3/x2
Cash flow hedge
107,216
Fair value hedge
107,216
There should not be any significant difference between the designation as a cash flow hedge or
a fair value hedge. There is no difference if there is no discounting of the future cash flows.
Problem 10.12
The calculation of the fair value of the swap is shown below:
LIBOR
+
150 bp
Fixed
rate
payments
Floating
rate
receipts
30/06/20x3
5.5%
1,375,000
1,375,000
31/12/20x3
6.0%
1,375,000
1,500,000
30/6/20x4
6.5%
1,375,000
31/12/20x4
6.2%
30/6/20x5
31/12/20x5
Date
1/1/20x3
Net
receipts
(payments)
Fair
value of
swap
Change in
fair value of
swap
576,573
576,573
125,000
929,275
352,702
1,625,000
250,000
492,637
(436,637)
1,375,000
1,550,000
175,000
238,838
(253,800)
6.0%
1,375,000
1,500,000
125,000
72,816
(166,022)
5.8%
1,375,000
1,450,000
75,000
0
(72,816)
30 June 20x3
Dr
Interest expense
1,375,000
Cr
Bank
(Payment of interest on floating rate loan)
1,375,000
Dr
Interest rate swap
576,573
Cr
Fair value adjustment (equity)
576,573
(Record change in fair value of swap)
31 December 20x3
Dr
Interest expense
1,500,000
Cr
Bank
(Payment of interest on floating rate loan)
1,500,000
25
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Dr
Bank
125,000
Cr
Interest receipt
(Receipt of swap differential)
125,000
Dr
Interest rate swap
352,702
Cr
Fair value adjustment (equity)
352,702
(Record change in fair value of swap)
30 June 20x4
Dr
Interest expense
1,625,000
Cr
Bank
(Payment of interest on floating rate loan)
1,625,000
Dr
Bank
250,000
Cr
Interest receipt
(Receipt of swap differential)
250,000
Dr
Fair value adjustment (equity) 436,637
Cr
Interest rate swap
(Record change in fair value of swap)
436,637
31 December 20x4
Dr
Interest expense
1,550,000
Cr
Bank
(Payment of interest on floating rate loan)
1,550,000
Dr
Bank
175,000
Cr
Interest receipt
(Receipt of swap differential)
175,000
Dr
Fair value adjustment (equity) 253,800
Cr
Interest rate swap
253,800
(Record change in fair value of swap)
30 June 20x5
Dr
Interest expense
1,500,000
Cr
Bank
(Payment of interest on floating rate loan)
1,500,000
Dr
Bank
125,000
Cr
Interest receipt
(Receipt of swap differential)
125,000
Dr
Fair value adjustment (equity) 166,022
Cr
Interest rate swap
166,022
(Record change in fair value of swap)
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31 December 20x5
Dr
Interest expense
1,450,000
Cr
Bank
(Payment of interest on floating rate loan)
1,450,000
Dr
Bank
Cr
Interest receipt
(Receipt of swap differential)
75,000
75,000
Dr
Fair value adjustment (equity) 72,816
Cr
Interest rate swap
72,816
(Record change in fair value of swap)
Problem 10.13
(1)
The hedged item was the forecasted cash flow of the anticipated transaction.
The hedging instrument is the entire instrument (no separation of time value). Hedge
effectiveness is assessed by comparing the change in spot price of silver coins (not
silver) with the change in the price of the futures contract multiplied by the notional
amount.
1/10/x1
28/2/x2
31/3/x2
$3.27
$3.15
$3.10
5,000,000
5,000,000
5,000,000
5,000,000
16,500,000
16,325,000
15,750,000
15,500,000
-175,000
-575,000
-250,000
$3.17
$3.05
$3.00
$200,000
$800,000
$1,050,000
Hedged item
Spot price of silver coin
$3.30
Quantity
Expected cash flows
Change in expected cash
flows
Futures contract
Exercise price
$3.21
FV of futures contract
31/12/x1
Period-to-period hedge effectiveness assessment
Gain (loss) on
Gain (loss) on
expected
future
Delta
Date
futures contract
cash flows
Ratio
31/12/20x1
200,000
-175,000
1.14
28/2/20x2
600,000
-575,000
1.04
31/3/20x2
250,000
-250,000
1
27
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Hedge effectiveness assessment on a cumulative basis
Cumulative
Gain (loss)
on futures
Contract
200,000
800,000
1,050,000
Date
31/12/20x1
28/2/20x2
31/3/20x2
Cumulative
Gain(loss)
on expected
cash flows
-175,000
-750,000
-1,000,000
Hedge
Ratio
1.14
1.06
1.05
The hedge was effective throughout the life of the futures contract.
(2) Journal entries [assume hedge effectiveness is assessed on a cumulative basis]
1 October 20x1
Dr
Margin deposit
150,000
Cr
Cash
150,000
[Margin deposit: $0.03 per pound of notional quantity]
31 December 20x1
Dr
Cr
Cr
Futures contract
Hedging reserve
Profit or loss
200,000 [(3.21 – 3.17) x 5,000,000]
175,000
25,000
[Because the cumulative gain in the fair value of the futures contract is greater than the
cumulative loss on the expected cash flows, the effective portion in the change in the
fair value of the futures contract that is taken to equity is the lesser of the two cumulative
amounts. The excess of the gain in fair value of the futures contract over the cumulative
loss on the expected cash flows is recognized in profit or loss as the ineffective portion.
Note that there is no separation of time value component as the hedge documentation
did not exclude it.]
As for the margin deposit, no top up is necessary since there is a gain on the futures
contract. In practice, there is daily settlement but for the purpose of this question it is
ignored.
28 February 20x2
Dr
Cr
Cr
Futures contract
Hedging reserve
Profit or loss
600,000 [(3.17 – 3.05) x 5,000,000]
575,000
25,000
[Because the cumulative gain in the fair value of the futures contract is greater than the
cumulative loss on the expected cash flows, the effective portion in the change in the
fair value of the futures contract that is taken to equity is the lesser of the two cumulative
amounts. The excess of the gain in fair value of the futures contract over the cumulative
loss on the expected cash flows is recognized in profit or loss as the ineffective portion.]
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31 March 20x2
Dr
Futures contract
250,000
Cr
Hedging reserve
250,000
[Effective portion in the change in the fair value of the futures contract is taken to equity;
there is no ineffective portion]
Dr
Cr
Cash
Sales
15,500,000
Dr
Cr
Cost of sales
Inventory
15,000,000
15,500,000
15,000,000
Dr
Hedging reserve
1,000,000
Cr
Sales
[To ‘recycle’ hedging reserve against sale.]
Dr
Cash
1,200,000
Cr
Margin deposit
Cr
Futures contract
[Close position on futures contract]
1,000,000
150,000
1,050,000
(3)
Sales
COGS
Gross profit
Gain on futures contract
Net profit
Without hedging
With hedging
15,500,000
(15,000,000)
500,000
__________
$500,000
16,500,000
(15,000,000)
1,500,000
50,000
$1,550,000
Problem 10.14
(1) Journal entries
The journal entries are based on the following computations:
1/10/x1
28/2/x2
31/3/x2
$3.265
$3.15
$3.10
5,000,000
5,000,000
5,000,000
5,000,000
16,500,000
Hedged item
Spot price of silver coin
$3.30
Quantity
Fair value of inventory
31/1/x1
16,325,000
15,750,000
15,500,000
Change in fair value
-175,000
-575,000
-250,000
Cumulative change in fair value
(175,000)
(750,000)
(1,000,000)
$0.175
$3.30
$0.20
Options contract
Premium
$0.12
$0.13
Exercise price
$3.30
$3.30
$3.30
29
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FV of options
$600,000
$650,000
$875,000
$1,000,000
Intrinsic value
$
-
$175,000
$750,000
$1,000,000
Time value
$600,000
$475,000
125,000
$0
1
1
1
Delta ratio
1/10/x1
Dr
Option contract
Cr
Cash
Purchase of option contract
600,000
600,000
31/12/x1
Dr
Loss in fair value of inventory
175,000
Cr
Inventory
Record change in the fair value of the inventory
175,000
Dr
Loss in time value of option
125,000
Cr
Options contract
Record loss in time value of the option contract
125,000
Dr
Options contract
175,000
Cr
Gain in intrinsic value
Record gain in intrinsic value of the option contract
175,000
28/2/x2
Dr
Loss in fair value of inventory
575,000
Cr
Inventory
Record change in the fair value of the inventory
575,000
Dr
Loss in time value of option
350,000
Cr
Options contract
Record loss in time value of the option contract
350,000
Dr
Options contract
575,000
Cr
Gain in intrinsic value
Record gain in intrinsic value of the option contract
575,000
31/3/x2
Dr
Loss in fair value of inventory
250,000
Cr
Inventory
Record change in the fair value of the inventory
250,000
Dr
Loss in time value of option
125,000
Cr
Options contract
Record loss in time value of the option contract
125,000
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Dr
Options contract
250,000
Cr
Gain in intrinsic value
Record gain in intrinsic value of the option contract
250,000
Dr
Cash
Cr
Option contract
Close option position
1,000,000
1,000,000
Dr
Cash
Cr
Sales
Sale of inventory
15,500,000
Dr
Cr
14,000,000
15,500,000
Cost of sales
Inventory
14,000,000
(2)
Without hedging
Sales
COGS
Gross profit
Net gain on option contract
Loss on inventory
Profit
15,500,000
(15,000,000)
500,000
$500,000
With hedging
15,500,000
(14,000,000)
1,500,000
400,000
(1,000,000)
$900,000
Problem 10.15
Transaction 1: Fair value hedge
31 July
20x5
30 Sept
20x5
Price of AFS
$2.50
$2.20
Quantity
100,000
100,000
Fair value of AFS
$250,000
$220,000
Change in FV of AFS
($30,000)
Put Option
Exercise price
$2.48
$2.48
Option price
$0.03
$0.28
Notional amount
100,000
100,000
Fair value of option
$3,000
$28,000
Intrinsic value
Time value
Delta ratio
$3,000
28,000
$0
0.93*
*The hedge would be fully effective if the put option is designated as a hedge of the share price
of Hindz Company falling below $2.48.
31
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Journal entries:
31 July 20x5
Dr
Investment (AFS)
Cr
Cash
(Investment in AFS)
Dr
Put option
Cr
Cash
(Purchase of put option)
30 September 20x5
Dr
Loss on fair value (AFS)
Cr
Investment (AFS)
Change in fair value of AFS
250,000
250,000
3,000
3,000
30,000
30,000
Dr
Put option
25,000
Cr
Gain on put option
25,000
(Change in fair value of put option: Gain in intrinsic value ($28,000) and loss on time
value ($3,000).
Dr
Cash
Cr
Put option
(Close option position)
28,000
28,000
Transaction 2: (Cash flow hedge)
Journal entries:
31 March 20x5
Dr
Interest expense
900,000
Cr
Cash/bank
900,000
Interest expense for the quarter ended 31 March
Dr
Swap asset
666,273
Cr
FV adjustment (equity)
Change in fair value of swap
666,273
30 June 20x5
Dr
Interest expense
1,000,000
Cr
Cash/bank
1,000,000
Interest expense for the quarter ended 31 March
Dr
Cash/bank
100,000
Cr
Interest expense
Net settlement at end of June quarter
Dr
Cr
Swap asset
477,931
FV adjustment (equity)
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100,000
477,931
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Chapter 10 Solutions
Change in fair value of swap
30 September 20x5
Dr
Cr
Interest expense
Cash/bank
1,100,000
Dr
Cr
Cash/bank
Interest expense
200,000
Dr
Cr
FV adjustment (equity)
Swap asset
1,100,000
200,000
470,697
470,697
Transaction 3: Hedge of net investment
Spot
Contracted
Date
Rate
Fwd rate
1/1/x5
1.8
31/3/x5
1.785
1.78
30/6/x5
1.765
30/9/x5
1.75
Current
Fwd
rate
Notional
amount
$’000
Fair value
of
Fwd
contract
$’000
Change
in
FV
of
fwd
$’000
Spot
Interest
element
Component
$’000
$’000
$0
$0
$0
$0
$0
1.77
2,240
22.4
$22.4
33.6
(11.20)
1.78
1.755
2,240
56.0
$33.6
44.8
(11.20)
1.78
1.742
2,240
85.12
$29.12
33.6
(4.48)
Hedged item: US$2,800,000 x 0.8 = US$2,240,000
The critical terms match and with time value being excluded from the hedge relationship, the
hedge is perfectly effective.
Journal entries
1 January 20x5
No entry required.
31 March 20x5
Dr
Dr
Cr
Forward contract
Interest component (P/L)
FCTR (Equity)
22,400
11,200
Forward contract
Interest component (P/L)
FCTR (Equity)
33,600
11,200
33,600
30 June 20x5
Dr
Dr
Cr
44,800
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30 September 20x5
Dr
Dr
Cr
Forward contract
Interest component (P/L)
FCTR (Equity)
29,120
4,480
33,600
Exchange loss on the hedged item:
The hedged item is the net investment in the subsidiary.
Foreign currency translation reserve (FCTR) will be recognized through the normal translation
process and will be in the opposite direction of the hedging instrument. As the FC depreciates,
the FCTR arising from translation will be a loss.
(2) Effects on financial statements for the year ending 30 September 20x5
Income statement
Change in FV of AFS
Gain on put option
Interest expense
Interest component of
forward contract
(30,000)
25 ,000
(2,700,000)
(26,880)
Balance sheet
Equity
FV Adjustment (swap)
673,507
Assets
Available-for-sale
Forward contract
Swap asset
220,000
85,120
673,507
Equity
FCTR
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112,000*
Advanced Financial Accounting (Tan, Lim and Kuah)
Chapter 10 Solutions
* The FCTR on the hedging instrument will be offset by the FCTR on the hedged item.
However, the final net amount will not be zero as the net investment in OGRE will be larger
than the initial amount hedged.
Problem 10.16
Convert to SGD/USD rates
FX rates:
SGD/USD spot
1 January 2010
30 June 2010
31 December 2010
30 June 2011
1/1.40=0.7143
1/1.38=0.7246
1/1.32= 0.7576
1/1.20=0.8333
SGD/USD forward
maturing 30 June 2011
1/1.37=0.7299
1/1.36=0.7353
1/1.29=0.7752
1.20=0.8333
Time value
0.7299-0.7143 =0.01564
0.7353-0.7246=0.01066
0.7752-0.7576=0.0176
0.8333-0.8333=0
30 Jun 2010 (figures in USD)
Change in fair value of FX forward during cash flow hedge period
Dr Loss on time value (P/L) (0.0156-0.0107)*S$1.4m
6,860
Dr Forward contract (0.7353 – 0.7299)*S$1.4m
7,560
Cr Deferred gain (OCI) (0.7246 – 0.7143)*S$1.4m
14,420
31 Dec 2010 FX loss on firm commitment
Dr Loss on firm commitment (0.7576-0.7246)*S$1.4m
Cr Firm commitment (payable)
46,200
46,200
Dr Forward contract (0.7752-0.7353)*S$1.4m
Cr Gain on forward contract (P/L)
55,860
Dr Equipment (0.7576*S$1.4m)
Cr Equipment payable
1,060,640
Dr Deferred gain (OCI)
Dr Firm commitment (payable)
Cr Equipment
14,420
46,200
55,860
1,060,640
60,620
Effective cost of equipment = (1,060,640-60,620)/1,400,000 = 0.7143
30 June 2011
Dr FX loss on equipment payable
Cr Equipment payable (0.8333-0.7692)*S$1.4m
89,740
89,740
Dr Equipment payable
Cr Cash (US$1.4m x 0.8333)
1,166,620
Dr Forward contract (0.8333-0.7752)*S$1.4m
Cr Gain on forward contract (P/L)
81,340
Dr Cash (0.8333-0.7299)*S$1.4m
Cr Forward contract
(Cash settlement locked in forward rate of 0.7299)
144,714
1,166,620
81,340
144,714
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Chapter 10 Solutions
31 Dec 2011
Depreciation for equipment
Dr Depreciation expense (1,076,880-76,860)/10
Cr Accumulated depreciation – Equipment
100,002
100,002
Problem 10.17
Swap interest settlement table (notional principal US$3,000,000) (figures in USD)
Date
Libor +
1%
1 Jan
2010
30 Jun
2010
31 Dec
2010
30 Jun
2011
31 Dec
2011
30 Jun
2012
31 Dec
2012
1.5%
(1)
(2)
(3)
(4)
Rec float
Pay fixed
1.5%
Net
receipt/
(payment)
Period to
maturity
Swap asset
(liability)
Change
swap
asset
0
1.75%
45,000
45,000
0
5
(1) 36,536
36,536
1.46%
52,500
45,000
7,500
4
(2) -4,714
-41,250
1.40%
43,800
45,000
(1,200)
3
(3) -8,876
-4,162
1.78%
42,000
45,000
(3,000)
2
(4) 16,578
25,454
53,400
45,000
8,400
1
PV(i=1.75%/2, PMT=3750, n=5) = 7,500*4.8714 = 36,536
PV(i=1.46%/2, PMT=-600, n=4) = -1,200*3.9281 = -4,714
PV(i=1.40%/2, PMT=-1500, n=3) = -3,000*2.9585 = -8,876
PV(i=1.78%/2, PMT=4200, n=2) = 8,400*1.9736 = 16,578
30 June 2010
Dr Swap Asset/Liability
Cr Swap fair value P/L (36,536*1.38)
31 Dec 2010
Dr Cash (7,500*1.32)
Cr Swap interest income (7,500*1.32) or (7,500*1.34)
Swap interest receipt
Dr Swap fair value P/L (41,250*1.32)
Cr Swap Asset/Liability
Swap fair valuation on 31 Dec 2010
30 Jun 2011
Dr Swap interest income (1200*1.2) (or 1200*1.25)
Cr Cash
Dr Swap fair value P/L (4,162*1.2)
Cr Swap Asset/Liability
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50,420
50,420
9,900
9,900
54,450
54,450
1,440
1,440
4,994
4,994
Advanced Financial Accounting (Tan, Lim and Kuah)
Chapter 10 Solutions
31 Dec 2011
Dr Swap interest income
Cr Cash (3,000*1.30)
Swap interest receipt
Dr Swap Asset/Liability
Cr Swap fair value P/L (25,454*1.30)
Swap fair valuation on 31 Dec 2011
1,950
1,950
33,090
33,090
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Advanced Financial
Accounting
An IFRS® Standards Approach, 3e
Pearl Tan, Chu Yeong Lim and Ee Wen Kuah
Solutions Manual
Chapter 11
Accounting for Taxes on Income
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Advanced Financial
Accounting
An IFRS® Standards Approach, 3e
Pearl Tan, Chu Yeong Lim and Ee Wen Kuah
Solutions Manual
Chapter 12
Earnings per Share
Copyright © 2016 by McGraw-Hill Education (Asia)
Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 12
CHAPTER 12
CONCEPT QUESTIONS
1
Earnings per share is significant to investors for two main reasons. First, by itself, it is a
widely used performance measure. This ratio provides investor with an indication of the
earnings per unit of share that they owned. Indirectly, it also provides an indication of the
maximum possible dividend they could expect to receive. Second, earnings per share is an
important input for another widely used investment ratio – the price-earnings ratio.
2
Basic earnings per share is based a historical ratio as it is based on actual reported earnings.
Diluted earnings per share is a hypothetical ratio in that it includes potentially dilutive
securities and assumes full conversion of these securities. Whether the potentially dilutive
securities will be converted depends on future events.
3
Basic earnings per share decreased in 20x5 while diluted earnings per share increased. Both
the numerator and the denominator increased in 20x5 for the basic earnings per share.
However, the increase in the denominator is proportionately greater than the numerator.
The possible reason is that in 20x5 there has been partial conversion of some potentially
dilutive securities which increased the denominator. In the case of the diluted earnings per
share, the numerator increased but the denominator remained constant. This is because the
potentially dilutive securities were assumed to be fully converted to ordinary shares in both
20x4 and 20x5.
4
The rationale for reporting diluted earnings per share is to provide forward looking
information on the dilutive effect of potential ordinary shares. The information is
considered relevant as it enhances comparability of a firm’s performance over time. It also
allows investors to assess the potential impact on share price as a result of the potential
dilution.
5
The limitations of earnings per share are:
(a) It is based on historical accounting numbers. If the historical accounting numbers
are suspect, for example, because of errors or earnings management, then the
earnings per share figure may not be a reliable indicator of performance.
(b) It does not facilitate comparability across firms.
(c) Unlike ratios like return on equity or return on asset, it does not take into account
changes in the capital base. As a result, it does not provide an accurate measure of
the return on capital.
6
If a dilutive security is anti-dilutive, it is excluded from the calculation of diluted earnings
per share. One reason is that it is not consistent with the objective of reporting diluted
earnings per share. Another reason is that if the potential ordinary share is anti-dilutive, it
is unlikely to be converted or exercised.
2
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Solutions to Chapter 12
PROBLEMS
Problem 12.1
(Note: It is assumed that the ordinary share has a par value of $1 per share. Capital structure refers
only to the share capital and long-term debt; it is differentiated from equity structure, which includes
retained earnings and capital reserves.)
Basic earnings per share (20x5) = Net profit attributable to ordinary shareholders
Weighted average number of shares
=
$2,584,400/9,437,500
= 27.38 cents
Net profit attributable to ordinary shareholders:
Net profit before preference dividends
$2,800,000
Preference dividends (1.1.20x5 to 30.9.20x5)*
(180,000)
Preference dividends (1.10.20x5)**
(36,000)
$2,584,000
*$5,000,000 x 3.6%
**$3,000,000 x 1.2%
Calculation of weighted average number of shares:
From 1 January to 30 September (Note a)
9,250,000 x 9/12
=
6,937,500
From 1 October to 31 December
10,000,000 x 3/12
=
2,500,000
Weighted number of shares
9,437,500
Note (a)
Total number of ordinary shares at 1 October
10,000,000
Less number of shares issued on conversion of pref. Shares
(750,000) Note( b)
Number of ordinary shares before conversion*
9,250,000
*including bonus issue
Note (b):
Conversion of preference shares:
60% = 300,000 preference shares (after conversion)
40% = 200,000 preference shares converted
3
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Conversion ratio = (5/2)
Number of ordinary shares issued = 200,000 x 5/2 =
500,000 shares
Adjustment for bonus issue (1 for 2)
250,000
Total number of ordinary shares issued on conversion
750,000
Diluted earnings per share
= adjusted net profit attributable to ordinary shareholders*
adjusted weighted average number of shares
=
$2,800,000/11,125,000 = 25.17 cents
* net profit attributable to ordinary shareholders + preference share dividends
Adjusted weighted average number of shares:
Number of ord. shares before conversion of preference shares
Add: assumed conversion of preference shares [750,000* x 5/2 ]
9,250,000
1,875,000
11,125,000
*Adjusted for bonus issue: 500,000 preference shares x 3/2
(2)
Basic earnings per share (20x4) = Net profit attributable to ordinary shareholders
Weighted average number of shares
= $2,500,000 - $240,000*
6,166,667**
= 36.65 cents
*$5,000,000 x 0.048
** Number of shares after bonus issue =
Bonus issue (9,250,000/3)
No. of shares before bonus
9,250,000
(3,083,333)
6,166,667
Check: 6,166,667 + 3,083,333 (1 for 2 bonus issue) = 9,250,000
Diluted earnings per share (20x4)
=
Net profit attributable to ordinary shareholders
Adjusted weighted average number of shares
=
$2,500,000 – 0 (nil preference dividends)
6,166,667 + 1,250,000
=
$2,500,000
7,416,667
=
33.71 cents
4
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Solutions to Chapter 12
Note: In the 20x5 financial statements, the comparative 20x4 earnings per share will be adjusted for
the bonus issue as follows:
Basic EPS (20x4 comparative)
=
(Alternatively: $2,260,000/9,250,000)
36.65 cents x 2/3 = 24.43 cents
Diluted EPS (20x4 comparative)
=
33.71 cents x 2/3 = 22.47 cents
(Alternatively: $2,500,000/(9,250,000 + 1,875,000)
Problem 12.2
Basic earnings per share (20x3) =
$5,000,000/15,000,000 =
33.33 cents
Calculation of weighted average number of shares:
From 1.1.20x3 to 30.6.20x3
12,000,000 shares x 6/12
= 6,000,000
From 1.7.20x3 to 31.12.20x3
18,000,000 shares x 6/12
= 9,000,000
Average weighted number of shares
Diluted earnings per share =
15,000,000
Adjusted net profit attributable to ordinary shareholders*
Adjusted weighted average number of shares
Calculation of adjusted net profit:
Net profit as reported
$5,000,000
Add: effective interest (net of tax)
399,123 (Note a)
$5,399,123
Note (a):
IAS 32 requires the convertible bond to be separated into debt and equity components as follows:
Debt component: PV of interest (6%, 5 years)
PV of principal
$
842473
$7,472,582
$8,315,054
Effective interest for 20x3 = $8,315,054 x 0.06 = $498,903
Less tax @ 20%
Interest (net of tax) saved
(99,780)
$399,123
Note: The convertible bond is dilutive as the incremental earnings per share is
$399,123/5,000,000 = 7.98 cents (lower than basic earnings per share).
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Solutions to Chapter 12
Calculation of weighted average number of shares for diluted earnings per share:
Weighted average number of shares for basic EPS
15,000,000
Add: ordinary shares issued at nil on assumed exercise of option
187,500
(2,000,000 - 2,000,000/1.60) x 3/12
Add: ordinary shares issued on assumed conversion of bond
5,000,000
Average weighted number of shares
20,187,500
Diluted earnings per share = $5,399,123/20,187,500 = 26.74 cents
Problem 12.3
(Note: It is assumed that the ordinary share has a par value of $1 per share and the convertible preference
shares have a par value of $5. Capital structure refers only to the share capital and long-term debt; it is
differentiated from equity structure which includes retained earnings and capital reserves.)
(1) The capital structure of Kops Ltd at 1 January 20x3 is as follows:
Movement of ordinary share capital during 20x3 and 20x4
20 million ordinary shares @ $1 each
$20,000,000
This is obtained by working backwards from 31 December 20x4 as follows:
No. of ord. Shares at 31.12.20x4
70,000
Less shares issued on 1.10.20x4
(8,000)
No. of ord. Shares at 30.9.20x4
62,000
Less ord. shares issued on conversion of pref. Shares
(2,000)
No. of shares at 30.6.20x4
60,000
Less bonus issue on 1.4.20x4
(30,000)
No. of shares at 1.1.20x4
30,000
Less ord. shares issued under rights issue on 1.7.20x3
(10,000)
No. of ord. shares at 1.120x3
20,000
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Solutions to Chapter 12
(2) Calculation of basic earnings per share
Basic EPS =
Net profit attributable to ordinary shareholders
Weighted average number of shares
Net profit attributable to ordinary shareholders:
Net profit for 20x3
less preference dividends
Profit attributable to ordinary shareholders
* 4,000,000 x $5 x 6.4% x 3/12
$12,800,000
( 320,000)*
$12,480,000
Calculation of weighted average number of shares during 1997.
Date
shares in
bonus element
time
weighted number
issue
in rights issue
weightage
of shares
1.1.20x3
20,000
1.9/1.6*
6/12
11,875
1.7.20x3
30,000
6/12
15,000
26,875
Note: The number of shares outstanding at 1.1.20x3 is multiplied by the bonus issue element (bonus
element is applied retroactively) and weighted by a time factor of 6/12 because the share capital was
enlarged by the rights issue from 1.7.20x3. The share capital from 1.7.20x3 to end of the year already
incorporated the bonus issue element. The 30,000 shares from 1.7.20x3 to 31.12.20x3 has to be time
weighted.
* Bonus element
=
cum-rights price/theoretical ex-rights price:
=
$1.90/$1.60
Ex-Rights price:
2,000 ord shares @ $1.9 =
1,000 rights shares @ $1
3,000 ord shares
$3,800
1,000
$4,800
Ex-rights price = $4,800/3,000 = $1.60
EPS (20x3)
=
$12,480,000/26,875,000
=
46.44 cents
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Solutions to Chapter 12
Calculation of profit attributable to ordinary shareholders for 20x4:
Net profit after tax
$14,500,000
Less preference dividends:
First two quarters*
Next two quarters**
Profit attributable to ordinary shares
(640,000)
(480,000)
$13,380,000
* On 4 million preference shares
** On 3 million preference shares
Date
Shares in
issue
1.1.20x4
30,000
1.4.20x4
Time
weightage
Weighted number
of shares (000)
3/12
15,000
60,000
3/12
15,000
1.7.20x4
62,000
3/12
15,500
1.10.20x4
70,000
3/12
17,500
63,000
Earnings per share (20x4) =
Bonus
issue
2
$13,380,000/63,000,000 = 21.24 cents
Comparative 20x3 earnings per share in 20x4 financial statements:
Net profit/adjusted weighted average no. Of shares = $12,480,000/(26,875,000 x 2)
= 23.22 cents
Problem 12.4
Calculation of basic earnings per share:
Net profit before preference dividends
Less preference dividends (1,200,000 x 0.68)
Net profit attributable to ordinary shares
Basic earnings per share =
$8,000,000
(816,000)
$7,184,000
$7,184,000/20,000,000 =
35.92 cents
Calculation of diluted earnings per share:
Calculation of average weighted number of shares:
Number of ordinary shares
20,000,000
Add: ordinary shares to be issued on assumed exercise of warrants
(1,000,000 – [5,000,000/6])
Add: ordinary shares to be issued on assumed conversion of pref. Shares
166,667
2,400,000
22,566,667
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Solutions to Chapter 12
Diluted earnings per share = $8,000,000/22,566,667 = 35.45 cents
Test of anti-dilution for convertible preference shares :
Incremental earnings per share = $816,000/2,400,000 = 34 cents.
The convertible preference shares are dilutive as the incremental earnings is less than the basic earnings
per share.
Problem 12.5
Basic earnings per share (20x1 – first half)
Profit from continuing operations
less preference share dividends (0.08 x 6,000,000)
Profit attributable to ordinary shareholders
$7,000,000
(480,000)
$6,520,000
Weighted average number of shares
30,000,000
Basic EPS (first half)
= $6,520,000/30,000,000
=
21.73 cents
Basic earnings per share (20x1 – second half)
Profit from continuing operations
less preference share dividends (0.08 x 1,000,000)
$2,800,000
(80,000)
$2,720,000
($1,500,000)
$1,220,000
Loss from discontinued operation
Profit attributable to ordinary shareholders
Weighted average number of shares
(Note a)
36,250,000
Basic EPS (second half):
Profit from continuing operations ($2,720,000/36,250,000) = 7.5 cents
Loss from discontinued operations (-$1,500,000/ 36,250,000) = (4.14) cents
Profit
3.37*
*Due to rounding difference of .01
Note (a): Calculation of weighted average number of shares:
Number of shares outstanding (1 Jul to 31 Dec)
Conversion of preference shares
Exercise of warrants (2,500,000 x 3/6)
Weighted average number of shares
30,000,000
5,000,000
1,250,000
36,250,000
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Solutions to Chapter 12
Basic EPS (20x1 – full year)
Profit from continuing operations
less preference share dividends
Loss from discontinued operation
Profit attributable to ordinary shareholders
Weighted average number of shares
(Note b)
$9,800,000
(560,000)
$9,240,000
($1,500,000)
$7,740,000
33,125,000
Basic EPS (full year):
Profit from continuing operations ($9,240,000/33,125,000) = 27.89 cents
Loss from discontinued operations (-$1,500,000/ 33,125,000) = (4.53) cents
Profit
23.36
Note (b): Calculation of weighted average number of shares:
Number of shares outstanding (12/12)
30,000,000
Conversion of preference shares (6/12)
2,500,000
Exercise of warrants (2,500,000 x 3/12)
625,000
Weighted average number of shares
33,125,000
Diluted earnings per share (20x1 – first half)
Profit from continuing operations
$7,000,000
less preference share dividends
0*
Profit attributable to ordinary shareholders
$7,000,000
*no dividend as all preference shares are assumed to be converted at beginning of year.
Calculation of weighted average number of shares:
Weighted average number of shares for basic EPS
Plus incremental shares on:
Assumed conversion of preference shares
Assumed exercise of warrants (Note c)
Adjusted weighted average number of shares
30,000,000
Diluted EPS (first half)
=
= $7,000,000/36,348,837
6,000,000
348,837
36,348,837
Note (c):
Proceeds from exercise: $4 x 5,000,000 = $20,000,000
Proceeds /Average price of $4.30
No. of shares deemed issued a nil
= 4,651,163 shares
=
5,000,000 – 4,651,163 = 348,837
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19.26 cents
Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 12
Diluted earnings per share (20x1 – second half)
Profit from continuing operations
Less preference share dividends
$2,800,000
(0)
$2,800,000
($1,500,000)
$1,300,000
Loss from discontinued operation
Profit attributable to ordinary shareholders
Weighted average number of shares
(Note d)
37,852,837
Note (d): Calculation of weighted average number of shares
Weighted average number of shares for basic EPS
Plus incremental shares on:
Assumed conversion of pref. Shares
Assumed exercise of warrants ( Note e)
Adjusted weighted average number of shares
36,250,000
1,000,000
602,837
37,852,837
Note (e)
Portion not converted assumed to be converted on 1 July 20x1
Proceeds from exercise: $4 x 2500000 = $10,000,000
Proceeds /average price of $4.80
No. of shares deemed issued at nil
= 2,083,333 shares
416,667 [2,500,000 – 2,083,333]
Portion converted on 1 October assumed to be converted at 1 July:
Proceeds from exercise: $4 x 2,500,000 = $10,000,000
Proceeds/average price of $4.70
No. of shares deemed issued at nil
= 2,127,660 shares
372,340
372,340 x 3/6 = 186,170 shares
Total incremental shares = 416,667 + 186,170 = 602,837 shares
Diluted EPS (second half):
Profit from continuing operations ($2,800,000/37,852,837) (cents)
=
7.40
Loss from discontinued operations (-$1,500,000/37,852,837) (cents)
=
(3.96)
Profit
=
3.44
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Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 12
Note: The incremental shares from assumed conversions are taken into account when calculating the
diluted EPS for the loss from discontinued operations though they are anti-dilutive. The reason is that
the control number is profit from continuing operations and the figure is a profit.
Diluted earnings per share (20x1 – full year)
Profit from continuing operations
Less preference share dividends
Loss from discontinued operation
Profit attributable to ordinary shareholders
Weighted average number of shares (Note f)
$9,800,000
(0)
$9,800,000
($1,500,000)
$8,300,000
37,159,421
Diluted earnings per share (20x1):
Profit from continuing operations ($9,800,000/37,159,421)
Loss from discontinued operations (-$1,500,000/37,159,421)
Profit
= 26.37 cents
= (4.04) cents
22.33 cents
Note (f)
Number of shares at 1 Jan 20x1
Conversion of pref. Shares
Conversion of warrants :
Actual conversion of warrants: 2,500,000 x 3/12
Assumed conversion (Note g)
Total
30,000,000
6,000,000
625,000
534,421
37,159,421
Note (g):
2,500,000 warrants exercised on 1 October now assumed to be exercised at 1 Jan 20x1
Proceeds from exercise: 2,500,000 x $4 =
$10,000,000
Proceeds/average market price (of $4.50) from 1 Jan to 1 Oct = 2,222,222 shares
Number of shares deemed issued at nil:
(2,500,000 – 2,222,222) x 9/12 = 277,798 x 9/12
208,334
2,500,000 warrants assumed to be exercised on 1 Jan 20x1
Proceeds from exercise: 2,500,000 x $4 =
$10,000,000
Proceeds/average market price of $4.60 for full year = 2,173,913 shares
Number of shares deemed issued at nil (2,500,000 – 2,173,913) =
Total
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326,087
534,421
Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 12
Problem 12.6
Basic EPS
=
Net profit attributable to ordinary shareholders
Weighted average number of shares
Net profit attributable to ordinary shareholders:
Net profit after tax
Less pref dividend
$2,800,000
(240,000) [4.8% x $5,000,000]
Net profit attributable to ordinary shareholders $2,560,000
Calculation of weighted average number of shares:
Number of shares outstanding/issued
At 1.1.20x3
20,000,000
At 1.4.20x3 - 1 for 4 bonus issue
5,000,000
Weighted average number of shares
25,000,000
Basic EPS (continuing operation)
=
=
2,560,000/25,000,000
10.24 cents
Basic EPS (discontinued operation)
=
-$3,000,000/ 25,000,000
=
-12 cents
=
[-$200,000 – $240,000]/25,000,000
=
- 1.76 cents
Net Loss
Calculation of diluted EPS (20x3)
Net profit for basic EPS
Add: Preference dividends
$2,560,000
240,000
$2,800,000
Add effective interest on convertible bond (net of tax)
153,916*
2,953,916
*Under IAS 32, the convertible bond has to be separated into debt and equity components and the
discount on the bond is amortised using the effective interest rate method. The effective interest is
calculated as follows:
$9,619,770 x 4% x 6/12 x (1 - 0.2) = $153,916 [see Note (a) below].
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Weighted average number of shares for diluted EPS:
Weighted average number of shares for basic EPS
25,000,000
Add: assumed conversion of convertible preference shares after
adjusting for bonus issue effect [5,000,000 x 500/1000 x 5/4]
3,125,000
Add: assumed conversion of convertible bonds [10,000,000 x 550/1000 x 6/12]
2,750,000
Weighted average number of shares for diluted EPS
30,875,000
Diluted earnings per share (continuing operation)
=
$2,953,916/30,875,000
=
9.57 cents
An alternative approach is as follows:
Numerator
As per basic EPS
Add convertible bonds
Add Pref shares
Denominator
Effect
Effect
2,560,000
25000000
153,916(a)
EPS
10.24 cents
2,750000
2,713,916
27,750,000
240,000
3,125,000
2,953,916
30,875,000
9.78 cents
9.57 cents
Diluted earnings per share (discontinued operation)
Diluted earnings per share (net)
=
-$3,000,000/30,875,000
=
-9.72 cents
=
($2,953,916 - $3,000,000)/30,875,000
=
-0.15 cents
Note: Although the potential ordinary shares are antidilutive (as they reduce the net loss per share)
diluted earnings per share is reported for all three components because the control number is profit
from continuing operation.
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Solutions to Chapter 12
Note (a): Calculation of debt component of convertible bond according to IAS 32:
Present value of debt component = $100,000 x 3.8077 + $10,000,000 x 0.9239
= $ 380,770 + $9,239,000
= $9,619,770
Discount on bond
= $10,000,000 - $9,619,770
= $380,230
Effective interest* ($192,395 x [1– 0.2]) = $153,916
*see below
Cash interest
Date
Effective
Amortisation
Unamortised
Carrying
value
Interest
expense
Discount
of bond
1.7.20x3
380,230
9,619,770
31.12.20x3
100,000
192,395
92,395
287,835
9,712,165
30.6.20x4
100,000
194,243
94,243
193,591
9,806,409
31.12.20x4
100,000
196,128
96,128
97,463
9,902,537
30.6.20x5
100,000
197,463
97,463
0
10,000,000
Earnings per share – 20x4
Movement in share capital during the year:
No of shares outstanding/issued
At 1.1.20x4
25,000,000
At 1.4.20x4 3-for5 rights
15,000,000
1.7.20x4 partial conversion of bond
2,200,000 (Note c)
1.9.20x4 induced conversion of PS
3,750,000 (Note d)
Number of shares outstanding at 31.12.20x4
45,950,000
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Weighted average number of shares:
No. of shares
Bonus issue in RI
1.1.20x4
25,000,000
2/1.7 (Note b)
1.4.20x4
Fraction of year Weighted No of shares
3/12
7,352,941
40,000,000
3/12
10,000,000
1.7.20x4
42,200,000
2/12
7,033,333
1.9.20x4
45,950,000
4/12
15,316,667
Weighted average number of shares
Add contingently issuable shares (adjusted for bonus issue):
Entitlement under agreement
Adjustment for bonus issue in 20x3 (1 for four)
Adjustment for bonus element in rights issue in 20x4
(125,000 000 x [2/1.7 – 1])
39,702,941
100,000
25,000
22,059
147,059
39,850,000
[[Note: The contingently issuable shares are included in the weighted number of shares as the necessary
condition has been satisfied.]
Note (b): Bonus element in rights issue:
Cum-rights price
$2
Subscription price
$1.20
Theoretical ex-right price
= (2 x 25,000000 + 1.2 x15,000,000)/40,000,000
= $68,000,000/40,000,000
= $1.70
Bonus adjustment factor
= 2/1.7 = 1.176
(Bonus element is 2/1.7 – 1 = .176)
Note (c): partial conversion of bond
$10,000,000 x 0.4 x 550/1000 = 2,200,000
Note (d): induced conversion of preference shares
5,000,000 x 750/1,000 = 3,750,000
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Net profit attributable to ordinary shareholders:
Net profit after tax (20x4)
$3,800,000
Less Preference dividends
(120,000) [$5000000 x 2.4%]
Less excess fair value paid to induce conversion
(183,824) Note (d)
Net profit attributable to ordinary shareholders
$ 3,496,176
Note (d)
Fair value of shares to induce conversion $2.50 x 3,750,000
=
$9,375,000
Fair value of shares under original conversion terms
=
$9,191,176*
Excess fair value
$183,824
*5,000,000 x 500/1000 x 1.25 (bonus issue) x 2/1.7 (bonus element in rights issue) x $2.50
Basic EPS (20x4)
=
$3,496,176/ 39,850,000
=
8.77 cents
Diluted earnings per share 20x4
The incremental earnings per share in respect of convertible preference shares (7.68 cents) is higher
than the basic earnings per share. The preference shares are anti-dilutive. This is shown in the following
table.
Numerator
Effect
As per basic EPS
3,496,176
Add: share options
________
3,496,176
Add convertible bonds
249,536(f)
3,745,712
Add Pref shares
303,824
4,049,536
Diluted EPS (20x4)
=
Denominator
Effect
39,850,000
EPS
8.77 cents
636,364 (e)
40,486,364
8.64 cents
3,300000 (g)
43,786,364
8.55 cents
2,426,470(h)
46,212,834
8.76 cents
8.55 cents (convertible preference shares are antidilutive)
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Notes:
(e) Shares deemed issued at nil under share options
No of potential ordinary shares 2,000,000 @ $1.50
(f)
=
$3,000,000
No. of shares deemed issued at nil [2,000,000 - $3,000,000/$2.20]=
636,364
Interest on bond:
$10,000,000 x 0.02 x 6/12
$ 6,000,000 x 0.02 x 6/12
Amortisation expense ($94,243 + $57,677)
Tax @ 20%
Effective interest net of tax
(g)
$ 100,000
60,000
151,920
$311,920
( 62,384)
$249,536
Assumed conversion of convertible bonds
Assumption: all convertible bonds converted at 1.1.20x4
Number of shares issued on assumed 100% conversion
[10,000,000 x 550/1000]
Less number of shares issued on actual conversion during year
Additional number of shares
5,500,000
-2,200,000
3,300,000
(h)
Number of ordinary shares based on original conversion ratio
[5,000,000 x 500/1,000]
Add: Adjustment for 1-for-4 bonus issue
2,500,000
625,000
3,125,000
Add: Adjustment for bonus issue element in rights issue
[3,125,000 x (2/1.7 – 1)]
551,470
3,676,470*
Less number of ordinary shares already included in basic EPS
(1,250,000)#
2,426,470
* Alternatively, it can be obtained as 3,125,000 x 2/1.7
# 3,750,000 x 4/12
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(2) 20x3’s comparative earnings per share in 20x4’s financial statements:
Basic EPS (adjusted for bonus element in rights issue)
Basic EPS (continuing operation)
=
=
2,560,000/(25,000,000 x 2/1.7)
8.7 cents
Basic EPS (discontinued operation)
=
-$3,000,000/ (25,000,000 x 2/1.7)
=
-10.2 cents
=
[-$200,000 – $240,000]/(25,000,000 x 2/1.7)
=
- 1.50 cents
Net Loss
Comparative diluted earnings per share :
Continuing operation
=
=
$2,953,916/(30,875,000 x 2/1.7)
8.13 cents
Discontinued operation
=
=
-$3,000,000/(30,875,000 x 2/1.7)
-8.26 cents
Diluted loss per share (net)
=
-0.13 cents
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Problem 12.7
Basic EPS for 20x2
Date
Item
1/1/20x2
1/5/20x2
1/7/20x2
1/11/20x2
31/12/20x2
Balance at start
Share repurchase
Bonus issues
Issue of new shares
Balance at year-end
Increase in
Ordinary shares
5,000,000
(1,200,000)
3,800,000
900,000
8,500,000
Add bonus
issue
5,000,000
(1,200,000)
Cumulative Period
balance
outstanding
Time
weight
Weighted
average shares
10,000,000 1 Jan – 30 April
7,600,000 1 May - 1 Oct
4/12
6/12
3,333,333
3,800,000
8,500,000 1 Nov - 31 Dec
2/12
1,416,667
8,550,000
Cumulative preference dividends
= 1.5% x 3 x $4,000,000
= $180,000
The reported preference dividends were $150,000 which did take into account the
dividends in arrears.
Profit attributable to ordinary shareholders
= Net profit after tax less preference share dividends
= $5,200,000 - $180,000
= $5,020,000
Basic EPS for 20x2
Weighted average shares
8,550,000
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Profit attributable to ordinary
shareholders
5,020,000
Basic EPS
$0.5871
Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 12
Convertible preference shares
Issued on 1 April 20x2
Units
4,000,000
Increase in
ordinary shares
from assumed
conversion
8,000,000
0.75
6,000,000
Diluted EPS for 20x2
Number of shares for denominator in Diluted EPS for 20x2
Number of shares in basic EPS
Incremental number of shares on assumed conversion of preference shares
Diluted EPS for 20x2
8,550,000
6,000,000
14,550,000
Profit attributable to ordinary
shares
5,200,000
Weighted
average
shares
14,550,000
Diluted EPS
$0.3573
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Problem 12.8
Basic EPS for 20X2
Date
1/1/20X2
1/4/20X2
1/8/20X2
1/10/20X2
Item
Balance at start
Issue of new shares
Share split
Conversion of pref shares
31/12/20X2
Balance at year-end
Increase in
Add shares Cumulative
ordinary shares
from split
balance
2,000,000
2,000,000
4,000,000
400,000
400,000
4,800,000
2,400,000
450,000
5,250,000
Period
outstanding
1 Jan - 31 Mar
1 Apr - 1 Oct
Time
weight
1 Oct - 31 Dec
1/4
1/2
Weighted
average shares
1,000,000
2,400,000
1/4
1,312,500
5,250,000
Basic EPS for 20x2
4,712,500
Profit attributable to OS
$6,846,750
WA shares
4,712,500
Basic EPS
$1.4529
Determine the Earnings per Incremental Share (EPIS) for each type of Potential Ordinary Shares
(a) Convertible Preference Shares
Incremental shares arising from the assumed conversion of the preference shares as at 1 Jan 20X2
(1) Preference shares that were converted on 1 Oct 20X2:
450,000
Assumed converted for period from 1 Jan 20X2 to 30 Sept 20X2
(2) Preference shares that were unconverted as at 31 Dec 20X2
500,000
Assumed converted for period from 1 Jan 20X2 to 31 Dec 20X2
Incremental shares arising from assumed conversion as at 1 Jan 20X2
Impact on profit attributable to ordinary shareholders from assumed conversion:
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337,500 (450000*9/12)
550,000
(550,000 x 12/12)
887,500
Advanced Financial Accounting (Tan, Lim and Kuah)
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Avoidance of dividends declared on preference shares during 20X2
Earnings per Incremental Share
53,250
0.0600 53250/887500
(b) Stock Options
Incremental shares arising from the assumed exercise of options as at 1 April 20X2 (date of issue)
No. of ordinary shares issued if outstanding options are exercised:
600,000
Equivalent number of shares at fair market value
520,000 (600000*2.6/3)
Incremental number of shares issued for no consideration
80,000
Incremental number of shares as at 1 April 20X2 (time-weight by 3/4)
60,000 (80000* 9/12)
Impact on profit attributable to ordinary shareholders from assumed exercise
Earnings Per Incremental Share
0
0 (0/60000)
(3) Convertible Bonds
Incremental shares arising from assumed conversion from convertible bonds as at 1 July 20X2 (date of issue)
Convertible bonds outstanding as at 1 July 20X2
6,000,000
Number of ordinary shares issued if the convertible bonds were converted on 1 Jul 20X2
3,000,000 5000000*1/2
Impact on profit attributable to ordinary shareholders from assumed conversion as at 1 July 20X2
Interest rate
Savings of interest expense (after-tax) on convertible bonds:
Earnings Per Incremental Share
5%
120,000 5%*6000000*1/2*80%
0.040
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Ranking by EPIS (EPIS)
(1) Stock Options
(2) Convertible Bonds
(3) Convertible Preference Shares
EPIS
0.00
0.040
0.0600
Most dilutive
Least dilutive
Determination of Diluted EPS
Weighted
average
number of shares
Profit
Basic EPS
Include effects of assumed exercise of options
Aggregate DEPS
Include effects of assumed conversion of convertible bonds
Aggregate DEPS
Include effects of assumed conversion of preference shares
Aggregate DEPS
Reported DEPS (20X2)
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6,846,750
4,712,500
0
60,000
6,846,750
4,772,500
120,000
3,000,000
6,966,750
7,772,500
53,250
887,500
7,020,000
8,660,000
DEPS
1.452891
1.434625 Dilutive
0.896333 Dilutive
0.810624 Dilutive
0.810624
Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 12
Problem 12.9
(Parts 1, 2 and 3 are reflected on this section)
20x1
Net profit after tax
Preference dividends
Net profit attributable to ordinary shareholders
Basic EPS
Diluted EPS
7,000,000
(30,000)
6,970,000
20x1
(Part 1 and 2)
Restated 20x1 (Part 3)
3.49 (Note 1)
3.11 (Note 2)
1.74 (Note 3)
1.56 (Note 4)
1/2*6%*1000000
20x2
1.452891
0.810624
Note 1: Basic EPS (20x1) = $6,970,000/2,000,000 = $3.49
Note 2: Diluted EPS (20x1) = $7,000,000 / (2,000,000 + 1,000,000 x ½ x 1/2)
= $7,000,000/2,250,000
= $3.11
2 preference shares were convertible to one ordinary share during 20x1. Hence, 1,000,000 convertible preference shares are convertible to 500,000 ordinary
shares. Since the convertible preference shares were issued on 1 July 20x1, the assumed converted shares are multiplied by ½.
After the share split, the exchange ratio was one to one.
Note 3: $3.49/2 = $1.74 (retrospective adjustment for share split)
Note 4: $3.11/2 = $1.56 (retrospective adjustment for share split)
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Part 4
Sapphire Ltd has fallen in profitability when the 20x2 EPS figures are compared with the restated comparatives. The comparison should be made
against the restated comparatives and not the previously reported EPS figures. The share splits resulted in new shares issued without consideration.
Even though the profit figures have remained stable, the relative performance on a per share basis has deteriorated.
P12.10
Calculate weighted average number of ordinary shares
Time-weighting
Shares in issue
Less: Treasury shares
Shares repurchased on 31 March 20x6
Shares repurchased on 30 September
20x6
Weighted average number of shares
2,000,000
(500,000) x 12/12
(50,000)x 9/12
(60,000)x 3/12
Calculate basic earnings per share
Basic EPS = Profit attributable to ordinary shareholders
Weighted average number of ordinary
shares
= 6,500,000 =4.49
1,447,500
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Number of shares
(500,000)
1,500,000
(37,500)
(15,000)
1,447,500
Advanced Financial
Accounting
An IFRS® Standards Approach, 3e
Pearl Tan, Chu Yeong Lim and Ee Wen Kuah
Solutions Manual
Chapter 13
Share-based Payment
Copyright © 2016 by McGraw-Hill Education (Asia)
Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 13
CHAPTER 13
CONCEPT QUESTIONS
1.
The three types of share-based transactions are:
(a) Equity –settled share-based payment transaction. These are transactions in which a firm
issues its own equity instruments as consideration for goods or services received from
its own employees or from third parties.
(b) Cash-settled share-based payment transactions. In these type of transactions, the firm
incurs a liability which is based on the fair value of its own equity instruments for goods
or services received from its own employees or from third parties.
(c) Share-based transactions with cash alternatives. These are transactions in which a firm
receives goods or services from its own employees or from third parties and the either
the firm or the counter party has the option of settling the transaction in cash or in the
form of equity instruments of the firm. The transaction is treated as a cash-settled sharebased transaction if the firm has incurred a liability to settle in cash. If no liability has
been incurred, the transaction is treated as an equity-settled share-based transaction.
2.
The explanations of the following terms are as follows:
(a) Grant date is the date when a firm and its own employees or a third party agrees to the
terms and conditions of a share-based payment transaction. If the agreement is
conditional upon the approval of shareholders of the firm, the grant date is the date
when shareholders approved the agreement.
(b) Measurement date is the date at which the fair value of a firm’s equity instrument is
measured for the accounting of a share-based payment transaction under IFRS 2. If the
counterparty in a share-based payment transaction is the firm’s own employees, the
measurement date is the grant date. If the counterparty is an outside party, the
measurement date is the date when the counterparty renders the service or delivers the
goods.
(c) Vesting date is the date at which the counterparty satisfied the vesting conditions of a
share-based payment transaction.
(d) Vesting conditions are the conditions in a share-based payment transaction that must
be satisfied by the counter-party before the latter is entitled to receive equity
instruments of the firm or cash under the share-based payment transaction.
(e) Forfeiture rate is the number (or percentage) of equity instruments expected to be
forfeited because of non-compliance with one or more vesting conditions.
3.
The methods of measuring the fair value of an entity’s equity instruments include:
(a) The quoted market price of the entity’s shares,
(b) An appropriate option valuation model such as the Black-Scholes model or
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(c) The intrinsic value method.
4.
There are two types of vesting conditions: service conditions and performance conditions.
Service conditions pertain to the stipulated service period that must be served before the
vesting condition is satisfied. Performance conditions usually incorporate a service
condition as well as a performance target such as the achievement of a certain level of sales
or profit. In respect of service conditions, if the equity instruments have not vested because
the counterparty has not completed the specified period of services, IFRS 2 requires that
the firm assumes that the services be rendered during the vesting period. The firm should
recognise an expense as the services are being rendered with a corresponding increase in
equity.
5.
The general principles in accounting for share-based transactions are as follows:
(a) When goods or services are received from the counterparty to a share-based
transaction, an expense must be recorded with a corresponding increase in equity.
(b) The issuer of the shares has to consider the timing of the provision of the service. If
the equity instruments are issued for past services, an expense has to be recorded
immediately. If the instruments are issued for future services, the expense is
recognized over the vesting period.
(c) In the case of services rendered by employees, the fair value of services rendered is
measured based on the fair value of the equity instruments at the date of the grant,
as typically, it is not feasible to measure reliably the fair value of services rendered by
employees. The fair value of the equity instruments estimated at the grant date is not
subsequently revised. The amount of expense to be recognized for services to be
rendered during the vesting period is based on the best available estimate of the
number of equity instruments expected to vest; this estimate is revised subsequently
if new information indicates that the number of equity instruments expected to vest
differs from the previous estimate.
(d) In the case of transactions with other parties who are not employees, the transaction
is measured based on the fair value of goods or services rendered at the date the
goods or services are received because the fair value of the goods or services can
normally be estimated reliably. However, in the exceptional case where this
presumption does not hold, the transaction is measured based on the fair market
value of the equity instruments granted.
6.
A vesting condition is a condition that must be met before the grantee is entitled to
receive compensation either in the form of cash or equity instruments of the entity.
Vesting conditions fall into one of two categories: service conditions or performance
conditions. As the term implies, a service condition stipulates that a specified period of
service must be completed by the employee or a third party providing services to the
entity. Performance conditions have two components: a service condition and a
performance target. A performance target may be a non-market related target such as
attaining a specified level of sales or profit over a specified period of time or a marketrelated condition which is normally tied to the market price of the firm’s shares or a share
index.
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7.
Repricing refers to the revision in the exercise price of a share option as a result of a
modification of the terms of a share option plan. If the repricing results in an increase in
the total fair value of the share-based arrangement, the firm should recognise the effect of
the repricing. However, if the repricing results in a decrease in the total fair value of the
share-based arrangement, the modification is ignored as if it had not been made.
8.
A share appreciation right is a type of share-based payment plan for employees under which
an employee is entitled to a cash payment equal to the increase in the share price over the
exercise price (the intrinsic value) at settlement date. The liability of the firm is measured
initially based on the fair value of the share appreciation rights and is remeasured at each
reporting period until the date of final settlement.
9.
IFRS 2 allows the a firm’s equity instruments to be measured at their intrinsic value in the
rare event that the firm is unable to reliably estimate the fair value of the equity instruments.
The intrinsic value is remeasured at each reporting date until the date of final settlement.
10.
In the case of equity-settled share-based transaction, the goods or services received and the
corresponding increase in equity must be measured at the fair value of goods or services
unless the fair value cannot be reliably estimated. The fair value of services rendered by
employees is measured by reference to the fair value of equity instruments at grant date.
This is due to the fact that normally they cannot be measured reliably. In a cash-settled
share-based transaction the entity incurs a liability for goods or services received. The fair
value of the liability has to be remeasured at each reporting date and at the date of
settlement. Any change in the fair value recognized in profit or loss for the period. There is
no such remeasurement for equity-settled transactions.
11.
Since P Co has an obligation to settle the share-based payment (SBP) with P Co’s equity
instruments, P has to recognize the SBP as equity-settled. S Co also recognizes the
transaction as an equity-settled because it receives the goods and services and has no
obligation to settle the SBP payment. The Group will recognize the SBP as equity-settled.
Journal entries
P Co (Equity-settled)
Dr Investment in S
Cr Equity
S Co (Equity-settled)
Dr Expense
Cr Equity contributions
Group (Equity-settled)
Dr Expense
Cr Equity
12.
In this situation, P Co has an obligation to settle the SBP with employees of its subsidiaries
S Co in S Co’s equity instruments. Since the settlement is in another entity’s instruments,
P Co recognizes the SBP as cash-settled. S Co recognizes the SBP as equity-settled as it is
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the recipient of the goods and services. The group recognizes the SBP as equity-settled as
the equity instruments issued are the group instruments.
Journal entries
P Co (Cash-settled)
Dr Investment in S
Cr Liabilities
S Co (Equity-settled)
Dr Expense
Cr Equity contributions
Group (Equity-settled)
Dr Expense
Cr Equity
13.
In this situation, S Co has an obligation to pay its employees remuneration that is pegged
to the price of shares of its parent, P Co. P Co has no obligation to settle the SBP and it is
also not a recipient of goods and services. No entry is required for P Co. For S Co and the
Group, the SBP is accounted for as a cash-settled SBP. S Co is the recipient of services and
it has an obligation to settle the instrument with reference to the share prices. S Co has
an obligation for future cash outflows to its employees. The same obligation applies to the
group.
Journal entries
S Co and Group (Cash-settled)
Dr Expense
Cr Liabilities
14.
P Co has an obligation to pay to employees of its subsidiary, S Co, remuneration that is
pegged to the price of shares of P Co. In this situation, P Co has an obligation to pay in
cash an amount that is pegged to the share price of its shares. It accounts for the SBP as a
cash-settled SBP and an increase in its investment in S Co. S Co is the beneficiary of the
SBP for services received and accounts for the benefit as an equity contribution from P Co
and the receipt of service as an expense. The group recognizes the expense for the services
received and a liability for the obligation for a future outflow of cash.
Journal entries
P Co (Cash-settled)
Dr Investment
Cr Liabilities
S Co (Equity-settled)
Dr Expense
Cr Equity contributions
Group (Cash-settled)
Dr Expense
Cr Liabilities
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Solutions to Chapter 13
EXERCISES
Exercise 13.1
(Note: This is a discussion question, so no calculation is required. Also, to calculate the remuneration
expense and the liability for each year, additional information pertaining to the fair value of the SARs
would have to be given.)
The share appreciation rights plan is a cash-settled share-based payment arrangement. IFRS 2 requires
a firm to recognise remuneration expense and a liability for services rendered. The fair value of the
liability is measured at 31 December 20x1 based on the estimated fair value of the SARs (this is not the
same as the share price). At 31 December 20x2, remuneration expense and the related liability is
remeasured. As long as the liability has not been fully settled, the liability is remeasured at each
subsequent reporting date. The cash paid out is equal to the intrinsic value of the SARS (share price less
exercise price) at the date of exercise. The liability is gradually reduced when the employees exercised
the SARs and will be fully extinguished when all the eligible employees have exercised the SARs or
the SARs have lapsed.
Exercise 13.2
IGRS 2 requires a firm to recognise the remuneration expense related to services provided by employees
under a share options plan. There are at least two approaches to measuring the remuneration expense to
be recognised in this question. One approach, which is the one favoured by IFRS 2, is to measure the
remuneration expense based on the fair value of the equity instruments issued by the firm. Another
approach is to measure remuneration expense based on the intrinsic value of the equity instruments.
This approach should be used in the rare situation where the fair value of the equity instruments cannot
be reliably measured. In this case, both the estimated fair value and the intrinsic values are provided.
The question is: is the fair value of the equity instruments capable of being fairly measured? The issue
is of great significance to the firm because the measurement approach used will have a great impact on
the firm’s reported earnings during the vesting period. If the fair value of $43 million is considered a
reliable estimate, then the remuneration expense, assuming no forfeiture during the vesting period, will
be $21.5 million for 20x3 and 20x4. However, if the $43 million is considered not a reliably estimated
amount, then measurement of remuneration expense should be based on the intrinsic value which is
$1.9 million in 20x3 and $2.6 million in 20x4.
The use of either the fair value of the equity instrument at grant date or the intrinsic value method also
has accounting consequences in terms of accounting for the tax effects of the remuneration expense. If
the fair value of the equity instrument is used to measure remuneration expense while the related tax
deduction is based on intrinsic value and recognised at the time of exercise, a temporary timing
difference is created. We need to evaluate whether the future tax deductions are greater or less than the
cumulative remuneration expense. If the future tax deductions are greater than the cumulative
remuneration expense, a portion of the tax effect will have to be recognised directly in equity and the
balance recognised in profit or loss. On the other hand, if the cumulative remuneration expense is greater
than the future tax deductions, the entire tax effect is recognised directly in profit or loss. Again there
is a difference in terms of impact on reported earnings.
Normally, the estimated fair value of the options at grant date and the intrinsic values at end of 20x3
and 20x4 should not differ significantly, especially if the estimation period is not long, which is
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usually the case with share options. In this case, the difference between the intrinsic values and the
estimated fair value is simply too great and this suggests that the estimated fair value may not be
reliably estimated. Therefore, measurement of the remuneration expense should be based on the
intrinsic value method.
Exercise 13.3
The share option carries a vesting condition which is a market condition since it has a target share
price. IFRS2 requires the recognition of an expense for services provided regardless of whether the
market condition is satisfied so long as other vesting conditions are satisfied. As the chief executive
was not expected to forfeit the share options, Delphi Company records the following journal enries:
31 May 20x4
Dr
Remuneration expense
Cr
Share options reserve
76,667
76,667
(Recognition remuneration expense : 100,000 options x $2.30 x 1/3)
31 May 20x5
Dr
Remuneration expense
Cr
Share options reserve
76,666
76,666
(Recognition remuneration expense : 100,000 options x $2.30 x 2/3 - $76,667)
31 May 20x6
Dr
Remuneration expense
Cr
Share options reserve
76,667
76,667
(Recognition remuneration expense : 100,000 options x $2.30 - $153,333)
(2)
1 June 20x6
Dr
Cr
Cr
Cash
Share option reserves
Share capital
300,000
230,000
530,000
(Record exercise of share options by chief executive officer and increase in share capital)
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Exercise 13.4
Journal entries:
31 December 20x1
Dr
IPO expense
Cr
Equity reserve
83,333
83,333
(Record receipt of services under an equity-settled share-based payment arrangement:
$500,000/6 months)
31 May 20x2
Dr
IPO expense
Cr
Equity reserve
416,667
416,667
(Record receipt of services under an equity-settled share-based payment arrangement:
$500,000 - $83,333)
Dr
Equity reserve
Cr
Share capital
500,000
500,000
(Transfer of equity reserve to share capital as IPO successfully launched)
PROBLEMS
Problem 13.1
(1) Calculation of expense relating to share options
Date
31.12.20x1
31.12.20x2
31.12.20x3
100 x 10,000 x 0.95 x $1.50 x
1/3
(100 x 10,000 x 0.95 x$1.50 x
2/3) – $475,000
100 x 10,000 x .94 x $1.50 $950,000
Current period
expense
$475,000
Cumulative expense
$475,000
$950,000
$460,000
$1,410,000
(2) Journal entries
31 December 20x1
Dr
Remuneration expense 475,000
Cr
Share option – reserve
(Record share option expense for 20x1)
31 December 20x2
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475,000
$475,000
Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 13
Dr
Remuneration expense 475,000
Cr
Share option – reserve
475,000
(Record share option expense for 20x2)
31 December 20x3
Dr
Remuneration expense 460,000
Cr
Share option – reserve
460,000
(Record share option expense for 20x3)
Problem 13.2
(1) The fair value of the equity alternative is $308,000 (11,000 shares × $2.80 x 10). The fair value of
the cash alternative is $300,000 (10,000 phantom shares × $3 x 10). Therefore, the fair value of the
equity component of the compound instrument is $8,000 ($308,000 – $300,000).
Assume the following scenarios at the end of 20x3:
Scenario 1: The employees chose the cash alternative.
Scenario 2: The employees chose the equity alternative.
(2) Calculation of remuneration expense and allocation to equity and liability are as follows:
Year
20x1
Expense
Equity
Liability
$
$
$
Liability component:
(10,000 × $3.50 × 10 x 1/3)
116,667
116,667
Equity component:
($8,000 × 1/3)
20x2
2,667
2,667
Liability component:
(10,000 × $4 × 10x 2/3) – $116,667
150,000
150,000
Equity component:
($8,000 × 1/3)
20x3
2,667
2,667
Liability component:
(10,000 × $5 x 10 – $266,667
233,333
233,333
Equity component:
($8,000 × 1/3)
End 20x3
Scenario 1: cash paid to settle liability
Scenario 1 totals
2,666
($500,000)
508,000
Scenario 2: 110,000 shares issued
Scenario 2 totals
2,666
508,000
508,000
0
508,000*
(500,000)
508,000
0
*issue of shares to settle total of the liability component
IFRS 2:38 requires that the remuneration expense is accounted for separately under the debt and the
equity components as follows:
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Debt component - the remuneration expense is accounted for in accordance with the requirements
applicable to cash-settled share-based payment transactions.
Equity component - the remuneration expense is accounted for in accordance with the requirements
applicable to equity-settled share-based payment transactions.
Note: the total remuneration is the same for both scenarios.
Journal entries (optional)
31 December 20x1
Dr
Remuneration expense
Cr
Share option reserves (equity)
Cr
Liability
(Record share option expense)
31 December 20x2
Dr
Remuneration expense
Cr
Share option reserves (equity)
Cr
Liability
(Record share option expense)
31 December 20x3
Dr
Remuneration expense
Cr
Share option reserves (equity)
Cr
Liability
(Record share option expense)
119,334
2,667
116,667
152,667
2,667
150,000
235,999
2,666
233,333
Under Scenario 1 (Employees chose cash alternative):
31 December 20x3
Dr
Liability
500,000
Cr
Cash
(Settlement of liability under share-based compensation plan)
500,000
Under Scenario 2 (Employees chose equity alternative):
31 December 20x3
Dr
Liability
500,000
Dr
Share option reserves (equity)
8,000
Cr
Share capital
508,000
(Settlement of liability under share-based compensation plan by issue of shares)
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Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 13
Problem 13.3
This is an equity-settled share-based payment transaction which should be measured based on the fair
value of the equity instruments granted. However, in rare cases such as this, where the entity is unable
to estimate reliably that fair value at the specified measurement date (e.g. grant date, for transactions
with employees), IFRS 2:24 requires the entity to measure the transaction using an intrinsic value
measurement method.
(1) Calculation of remuneration expenses
Current
period
expense
Cumulative
expense
$
$
Year
Calculations
20x1
(350,000 options × 28/35) × ($0.94 – $0.85) × 1/3 years
8,400
8,400
20x2
(350,000 options × 30/35) × (1.00 – $0.85) × 2/3 years – $8,400
21,600
30,000
20x3
300,000 options × ($1.10 – $0.85) – $30,000
45,000
75,000
20x4
100,000 outstanding options × ($1.20 – $1.10) +
30,000
105,000
5,000
110,000
200,000 exercised options × ($1.20 – $1.10)
20x5
100,000 exercised options × ($1.25 – $1.20)
(2)
Journal entries:
31 December 20x1
Dr
Remuneration expense
Cr
Share option reserve – equity
8,400
8,400
(Record share-based payment expense for 20x1)
31 December 20x2
Dr
Remuneration expense
Cr
Share option reserve – equity
21,600
21,600
(Record share-based payment expense for 20x2)
31 December 20x3
Dr
Remuneration expense
Cr
Share option reserve – equity
45,000
45,000
(Record share-based payment expense for 20x3)
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31 December 20x4
Dr
Remuneration expense
Cr
Share option reserve – equity
30,000
30,000
(Record share-based payment expense for 20x4)
Dr
Cash (200,000 x 0.85)
170,000
Dr
Share option reserve - equity
70,000
(200/300 x 105,000)
Cr
Share capital
240,000
(Record exercise of 200,000 options at end of 20x4)
31 December 20x5
Dr
Remuneration expense
Cr
Share option reserve – equity
5,000
5,000
(Record share-based payment expense for 20x5)
Dr
Cash (100,000 x 0.85)
85,000
Dr
Share option reserve – equity
40,000
(100/300 x 105,000 + 5,000)
Cr
Share capital
125,000
(Record exercise of 100,000 options at end of 20x5)
Problem 13.4
Note: IFRS 2:27 requires:
(1) Bonjour to recognize remuneration expense for services received over the three years. The
remuneration is measured base on the fair value of the equity instruments at grant date. This
requirement applies irrespective of any modifications to the terms and conditions on which the
equity instruments were granted, or a cancellation or settlement of that grant of equity
instruments.
(2) The addition of the cash alternative at the end of 20x2 creates an obligation to settle in cash.
Bonjour recognises the liability to settle in cash at the modification date, based on the fair value
of the shares at the modification date and the extent to which the specified services have been
received. (IFRS 2:30 - 33).
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Advanced Financial Accounting (Tan, Lim and Kuah)
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(3) Bonjour remeasures the fair value of the liability at each reporting date and at the date of
settlement, with any changes in fair value recognised in profit or loss for the period.
(1) Calculate the remuneration expense for 20x2, 20x3 and 20x4.
Remuneration expense for 20x2:
100,000 shares x $3 x 1/3
=
$100,000
Cumulative amount credited to equity
=
$100,000
(100,000 shares x $3 x 2/3) - $100,000
=
$100,000
Cumulative amount credited to equity
=
$200,000
Remuneration expense for 20x3:
The addition of a cash alternative at the end of 20x3 creates a liability (obligation to settle in cash) calculated as
follows:
100,000 shares x $2.70 x 2/3
=
$180,000
This amount is transferred from equity to liability resulting in a net balance of $20,000 in equity.
Remuneration expense for 20x4:
(100,000 shares x $3) - $200,000
Adjustment in fair value of liability
Remuneration expense for 20x4
=
$100,000
(20,000)*
$80,000
This amount is allocated between equity and liability as follows:
Equity ($20,000/$200,000 x $100,000)
=
$10,000
Liability ($180,000/$200,000 x $100,000)
=
$90,000
Cumulative amount in equity is $30,000.
*Since the share price has decreased further, the liability at vesting date is adjusted further.
Adjustment of liability to closing fair value =
=
($180,000 + $90,000) – 100,000 shares x $2.50
($20,000)
Summary:
Total expense over vesting period
Allocated between:
Equity
Liability
=
$280,000
$ 30,000
$250,000
$280,000
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Solutions to Chapter 13
Problem 13.5
Since the earnings in 20x1 increased by 13% and is expected to remain in the range of 10% and 15%
over the three year-period, the chief executive officer is entitled to 100,000 shares options.
Remuneration expense for 20x1:
100,000 share options x $5 x 1/3 = $166,667
At the end of 20x2, earnings for the three year period is expected to be more than 15%; hence the chief
executive officer is entitled to 150,000 share options.
Remuneration expense for 20x2:
(150,000 share options x $5 x 2/3) - $166,667 = $333,333
The actual rate of earnings growth over the three-year period is 10%. Therefore, the chief executive
officer is entitled to only 100,000 share options.
Remuneration expense for 20x3:
100,000 share options x $5 - $500,000 = $0
(2)
Journal entries:
31 December 20x1
Dr
Remuneration expense
Cr
Share option reserve – equity
166,667
166,667
(Record remuneration expense for 20x1.)
31 December 20x2
Dr
Remuneration expense
Cr
Share option reserve – equity
333,333
333,333
(Record remuneration expense for 20x2.)
31 December 20x3
No journal entry is recorded as remuneration expense is nil.
Problem 13.6
Year
20x1
20x2
Computations
Expense
Equity
Remuneration expenses for year:
100,000 shares options × 95 × $0.80 x ½
3,800,000
3,800,000
Remuneration expenses for year:
3,560,000
3,560,000
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(100,000 shares × 92 × $0.80) – $3,800,000
Journal entries:
(Record remuneration expense for 20x1.)
31 December 20x1
Dr
Remuneration expense
Cr
Share option reserve – equity
3,800,000
3,800,000
(Record remuneration expense for 20x1.)
31 December 20x2
Dr
Remuneration expense
Cr
Share option reserve – equity
3,560,000
3,560,000
(Record remuneration expense for 20x.)
Problem 13.7
In 20x1, earnings increase by 25% and the exercise price decreases by the same percentage point to
$2.25. The estimated fair value of the option is $1.875.
20x1 remuneration expense:
100,000 shares options × 10 × $1.875 x 1/3 = $625,000
In 20x2, earnings increase by 30%. Therefore, the exercise price decreases by 30% to $2.10 and the
estimated fair value of the option increases to $1.95
20x2 remuneration expense:
(100,000 shares options × 10 × $1.95 x 2/3) – $625,000 = $675,000
In 20x3, earnings increase by 33% and the exercise price decreases to $2.01. The estimated fair value
per option increases to $2.00
20x3 remuneration expense:
(100,000 shares options × 10 × $2) - $1,300,000 = $700,000.
31 December 20x1
Dr
Remuneration expense
Cr
Share option reserve – equity
625,000
625,000
(Record remuneration expense for 20x1.)
31 December 20x2
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Advanced Financial Accounting (Tan, Lim and Kuah)
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Dr
Remuneration expense
Cr
Share option reserve – equity
675,000
675,000
(Record remuneration expense for 20x2.)
31 December 20x3
Dr
Remuneration expense
Cr
Share option reserve – equity
700,000
700,000
(Record remuneration expense for 20x3.)
1 January 20x4
Dr
Share option reserve – equity
2,000,000
Dr
Cash (100,000 x 10 x 2)
2,000,000
Cr
Share capital
(Record exercise of options)
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4,000,000
Advanced Financial Accounting (Tan, Lim and Kuah)
Solutions to Chapter 13
Problem 13.8
(Please note that the cash actually paid out is the increase in share price over the exercise price, that is,
the intrinsic value.)
(1)
Calculation of remuneration expense
Date
20x1
20x2
20x3
20x4
20x5
Computations
20 x 10,000 x 0.95 x $4 x 1/3
(20 x 10,000 x 0.95 x $3.50 x 2/3) –
$253,333
(18 x 10,000 x $4.50) - $443,333
(8 x 10,000 x $4.20) - $810,000 +
10 x 10,000 x $3.90
8 x 10,000 x $4.30
Current period expense
$253,333
$190,000
Cumulative liability
$253,333
$443,333
$366,667
-$474,000 + $390,000 =
- $84,000
0 - $336,000 + $344,000
=
$8,000
$810,000
$336,000
0
(2) Journal entries
31 December 20x1
Dr
Remuneration expense
Cr
Liability
253,333
253,333
(Record remuneration expense and related liability of SARs for 20x1).
31 December 20x2
Dr
Remuneration expense
Cr
Liability
190,000
190,000
(Record remuneration expense and related liability of SARs for 20x2).
31 December 20x3
Dr
Remuneration expense
Cr
Liability
366,667
366,667
(Record remuneration expense and related liability of SARs for 20x2).
31 December 20x4
Dr
Liability
Cr
Remuneration expense
Cr
Cash
474,000
84,000
390,000
(Record writing back of remuneration expense and settlement of liability on exercise
of options)
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31 December 20x5
Dr
Remuneration expense
Dr
Liability
Cr
Cash
8,000
336,000
344,000
(Record remuneration expense and settlement of liability on exercise of options)
Summary of remuneration expenses:
20x1
253,333
20x2
190,000
20x3
366,667
20x4
(84,000)
20x5
8,000
Total
734,000
Check:
10 employees x 10,000 SARs x $3.90
8 employees x 10,000 SARS x $4.30
=
390,000
344,000
734,000
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