ACCA P2 Corporate Reporting

Knowledge Topic 4
FINANCIAL INSTRUMENTS AND
LEASES
Practise & Apply Question &
Answers
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1 Aron (6/09, amended)
The directors of Aron, a public limited company, are worried about the challenging market conditions
which the company is facing. The markets are volatile and illiquid. The central government is injecting
liquidity into the economy. The directors are concerned about the significant shift towards the use of
fair values in financial statements. IFRS 9 Financial instruments in conjunction with IFRS 13 Fair value
measurement defines fair value and requires the initial measurement of financial instruments to be at fair
value. The directors are uncertain of the relevance of fair value measurements in these current market
conditions.
Requirements
(a) Briefly discuss how the fair value of financial instruments is measured, commenting on the
relevance of fair value measurements for financial instruments where markets are volatile and
illiquid. (4 marks)
(b) Further they would like advice on accounting for the following transactions within the financial
statements for the year ended 31 May 20X8.
(i) Aron issued one million convertible bonds on 1 June 20X5. The bonds had a term of three
years and were issued with a total fair value of $100 million which is also the par value.
Interest is paid annually in arrears at a rate of 6% per annum and bonds, without the
conversion option, attracted an interest rate of 9% per annum on 1 June 20X5. The company
incurred issue costs of $1 million. If the investor did not convert to shares they would have
been redeemed at par. At maturity all of the bonds were converted into 25 million ordinary
shares of $1 of Aron. No bonds could be converted before that date. The directors are
uncertain how the bonds should have been accounted for up to the date of the conversion on
31 May 20X8 and have been told that the impact of the issue costs is to increase the effective
interest rate to 9.38%. (6 marks)
(ii) Aron held a 3% holding of the shares in Smart, a public limited company, The investment was
classified as an investment in equity instruments and at 31 May 20X8 had a carrying value of
$5 million (brought forward from the previous period). As permitted by IFRS 9 Financial
instruments, Aron had made an irrevocable election to recognise all changes in fair value in
other comprehensive income (items that will not be reclassified to profit or loss). The
cumulative gain to 31 May 20X7 recognised in other comprehensive income relating to the
investment was $400,000. On 31 May 20X8, the whole of the share capital of Smart was
acquired by Given, a public limited company, and as a result, Aron received shares in Given
with a fair value of $5.5 million in exchange for its holding in Smart. The company wishes to
know how the exchange of shares in Smart for the shares in Given should be accounted for in
its financial records. (4 marks)
(iii) Aron granted interest free loans to its employees on 1 June 20X7 of $10 million. The loans will
be paid back on 31 May 20X9 as a single payment by the employees. The market rate of
interest for a two year loan on both of the above dates is 6% per annum. The company is
unsure how to account for the loan but wishes to hold the loans at amortised cost under
IFRS 9 Financial instruments (4 marks)
Requirement
Discuss, with relevant computations, how the above financial instruments should be accounted for in
the financial statements for the year ended 31 May 20X8.
Note 1. The mark allocation is shown against each of the transactions above.
Note 2. The following discount and annuity factors may be of use.
Discount Annuity
factors factors
6% 9% 9.38% 6% 9% 9.38%
1 year 0.9434 0.9174 0.9142 0.9434 0.9174 0.9174
2 years 0.8900 0.8417 0.8358 1.8334 1.7591 1.7500
3 years 0.8396 0.7722 0.7642 2.6730 2.5313 2.5142
Professional marks will be awarded for clarity and quality of discussion. (2 marks)
(Total = 20 marks)

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Top tips. Part (a) required a brief discussion of how the fair value of financial instruments is determined
with a comment on the relevance of fair value measurements for financial instruments where markets
are volatile and illiquid. Part (b) required you to discuss the accounting for four different financial
instruments. The financial instruments ranged from a convertible bond to transfer of shares to a debt
instrument in a foreign subsidiary to interest free loans. Bear in mind that you need to discuss the
treatment and not just show the accounting entries. And while you may not have come across the
specific treatment of interest-free loans before, you can apply the principles of IFRS 9 (what is fair value
in this case?) and the Conceptual Framework.
Easy marks. These are available for the discussion in Part (a) and the convertible bond.
Examiner's comment. This was the best answered question on the paper. Part (a) was quite well
answered although the answers were quite narrow and many candidates simply described the
classification of financial instruments in loans and receivables, fair value through profit or loss etc. In Part
(b) many candidates simply showed the accounting entries without any discussion. If the accounting
entries were incorrect then it was difficult to award significant marks for the attempt. The treatment of
the convertible bond was quite well done except for the treatment of the issue costs and the conversion
of the bond. This part of the question often gained good marks. Again the treatment of the transfer of
shares and interest free loans was well done but the exchange and fair value gains were often combined
and not separated in the case of the debt instrument of the foreign subsidiary.

Marking guide

Marks

(a) Fair value subjective 4

(b) Convertible bond: explanation 2
Calculation 4
Shares in Smart: explanation 2
Calculation 2
Interest free loan: explanation of principles 2
accounting treatment 2
Quality of explanations 2
Available/Maximum 20

(a) Fair value

The fair value of an asset the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date (IFRS 13
Fair value measurement). IFRS 13 states that valuation techniques must be those which are
appropriate and for which sufficient data are available. Entities should maximise the use of relevant
observable inputs and minimise the use of unobservable inputs. The standard establishes a three-
level hierarchy for the inputs that valuation techniques use to measure fair value.
Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the
reporting entity can access at the measurement date
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly, eg quoted prices for similar assets in active markets or for
identical or similar assets in non-active markets or use of quoted interest rates for valuation
purposes
Level 3 Unobservable inputs for the asset or liability, ie using the entity's own assumptions about
market exit value
The IASB believes that fair value is the most appropriate measure for most financial instruments
because it is the most relevant. However, it, may be less reliable. There is more scope for
manipulation. Particular difficulties arise where quoted prices are unavailable. If this is the case
and it frequently is there is more reliance on estimates.

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 Not all markets are liquid and transparent. Where a market is illiquid, it is particularly difficult to
apply fair value measurement, because the information will not be available. In addition, not all
markets are stable; some are volatile. Fair valuing gives a measurement at a particular point in time,
but in a volatile market this measure may not apply long term. It needs to be considered whether
an asset is to be actively traded or held for the long term.
Disclosure is important in helping to deal with some of the problems of fair value, particularly as it
provides an indicator of a company's risk profile.
(b) (i) Convertible bond
Some financial instruments contain both a liability and an equity element. In such cases, IAS
32 requires the component parts of the instrument to be classified separately, according to
the substance of the contractual arrangement and the definitions of a financial liability and an
equity instrument.
One of the most common types of compound instrument, as here, is convertible debt. This
creates a primary financial liability of the issuer and grants an option to the holder of the
instrument to convert it into an equity instrument (usually ordinary shares) of the issuer. This
is the economic equivalent of the issue of conventional debt plus a warrant to acquire shares
in the future.
Although in theory there are several possible ways of calculating the split, the following
method is recommended:
(1) Calculate the value for the liability component.
(2) Deduct this from the instrument as a whole to leave a residual value for the equity
component.
The reasoning behind this approach is that an entity's equity is its residual interest in its assets
amount after deducting all its liabilities.
The sum of the carrying amounts assigned to liability and equity will always be equal to the
carrying amount that would be ascribed to the instrument as a whole.
The equity component is not re-measured. However, the liability component is measured
at amortised cost using an effective interest rate (here 9.38%).
It is important to note that the issue costs (here $1million) are allocated in proportion to the
value of the liability and equity components when the initial split is calculated.

Step 1 Calculate liability element

A 9% discount rate is used, which is the market rate for similar bonds without the
conversion rights:
Present value of interest at end of:
Year 1 (31 May 20X6) ($100m 6%) 0.9174 5,505
Year 2 (31 May 20X7) ($100m 6%) 0.8417 5,050
Year 3 (31 May 20X8) ($100m ($100m 6%)) 0.7722 81,852
Total liability component 92,407
Total equity element 7,593
Proceeds of issue 100,000
Step 2 Allocate issue costs
Liability Equity Total
$'000 $'000 $'000
Proceeds 92,407 7,593 100,000
Issue cost (924) (76) (1,000)
91,483 7,517 99,000

The double entry is:

$'000 $'000 $'000 $'000
DEBIT Cash 100,000 CREDIT Cash 1,000
CREDIT Liability 92,407 DEBIT 924
CREDIT Equity 7,593 bl
DEBIT Equity 76

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 Step 3 Re-measure liability using effective interest rate
$'000
Cash 1.6.20X5 (net of issue costs per Step 2) 91,483
Effective interest to 31.5.20X6 (9.38% 91,483) 8,581
Coupon paid (6% $100m) (6,000)
At 31.5.20X6 94,064
Effective interest to 31.5.20X7 (9.38% 94,064) 8,823
Coupon paid (6% $100m) (6,000)
At 31.5.20X7 96,887
Effective interest to 31.5.20X8 (9.38% 96,887) 9,088
Coupon paid (6% $100m) (6,000)
At 31.5.20X8 100,000*

Step 4 Conversion of bond

On conversion of the bond on 31 May 20X8, Aron will issue 25 million ordinary
shares. The consideration for these shares will be the original equity component
(net of its share of issue costs) together with the balance on the liability.
$'000
Share capital 25 million at $1 25,000
Share premium 82,517
Equity and liability components (100,000 + 7,593 76) 107,517

(ii) Shares in Smart

Firstly, the carrying value of the investment in shares in Smart of $5m (which is the fair value
as at 31 May 20X7) needs updating to the fair value at 31 May 20X8. The fair value of the
investment in shares in Smart at 31 May 20X8 is $5.5m this is because Given are prepared
to buy the shares in Smart and pay with consideration in the form of shares in Given with a
fair value of $5.5m. IFRS 13 Fair value measurement defines fair value as the 'price that would
be received to sell an assetbetween market participants at the measurement date'. Here the
price that Aron receives for shares in Smart is in the form of shares in Given worth $5.5m.
Aron should therefore recognise a gain on remeasurement of the investment in shares in
Smart of $0.5m ($5.5m - $5m) in other comprehensive income(items that will not be
reclassified to profit or loss):
DEBIT Financial Asset: Investment in shares in Smart $0.5m
CREDIT Remeasurement gain (in OCI: not reclassified to profit or loss) $0.5m.
The second issue here is whether the investment in shares in Smart should be derecognised.
Derecognition is the removal of a previously recognised financial instrument from an entity's
statement of financial position.
An entity should derecognise a financial asset when:
(a) The contractual rights to the cash flows from the financial asset expire, or
(b) The entity transfers substantially all the risks and rewards of ownership of the
financial asset to another party.
In this case, Aron no longer retains any risks and rewards of ownership in the investment in
shares in Smart (instead Aron now has access to the risks and rewards of ownership in the
investment in shares in Given). Accordingly the financial asset 'Investment in shares in Smart'
should be derecognised and instead a financial asset for the 'Investment in shares in Given'
should be recognised. No gain or loss on derecognition will arise.
The investment in shares in Smart of $5.5m is then derecognised and an investment in Shares
in Given is recognised instead:
DEBIT Financial asset: shares in Given $5.5m
CREDIT Financial asset: shares in Smart $5.5m.
Tutorial note. Both the revaluation gain at the date of derecognition taken to other
comprehensive income (not reclassified to profit or loss) of $500,000 and the cumulative gain
of $400,000 previously recognised in other comprehensive income (not reclassified to profit

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 or loss), and therefore held in other components of equity may be transferred to retained
earnings as a reserves movement.
(iii) Interest free loans
IFRS 9 Financial instruments requires financial assets to be measured on initial recognition at
fair value plus transaction costs. Usually the fair value of the consideration given represents
the fair value of the asset. However, this is not necessarily the case with an interest-free loan.
An interest free loan to an employee is not costless to the employer, and the face value may
not be the same as the fair value.
To arrive at the fair value of the loan, Aaron needs to consider other market transactions in
the same instrument. The market rate of interest for a two year loan on the date of issue (1
June 20X7) and the date of repayment (31 May 20X9) is 6% pa, and this is rate should be
used in valuing the instrument. The fair value may be measured as the present value of
future receipts using the market interest rate. There will be a difference between the face
value and the fair value of the instrument, calculated as follows:
$m
Face value of loan at 1 June 20X7 10.0
Fair value of loan at 1 June 20X7: 10 0.8900 8.9
Difference 1.1

The difference of $1.1m is the extra cost to the employer of not charging a market rate of
interest. It will be treated as employee compensation under IAS 19 Employee benefits. This
employee compensation must be charged over the two year period to the statement of profit
or loss and other comprehensive income, through profit or loss for the year.
With regard to subsequent measurement Aron wishes to hold the loan at amortised cost. For
this to be possible, two criteria must be met under IFRS 9:
(1) Business model test. The objective of the entity's business model is to hold the financial
asset to collect the contractual cash flows (rather than to sell the instrument prior to its
contractual maturity to realise its fair value changes).
(2) Cash flow characteristics test: The contractual terms of the financial asset give rise on
specified dates to cash flows that are solely payments of principal and interest on the
principal outstanding.
These criteria have been met. Accordingly, the loan may be measured at 31 May 20X8 at
amortised cost using the effective interest method. The effective interest rate is 6%, so the
value of the loan in the statement of financial position is: $8.9m 1.06 = $9.43m. Interest will
be credited to profit or loss for the year of: $8.9 6% = $53m.
The double entry is as follows:
At 1 June 20X7
DEBIT Loan $8.9m
DEBIT Employee compensation $1.1m
CREDIT Cash $10m
At 31 May 20X8
DEBIT Loan $0.53m
CREDIT Profit or loss interest for the year $8.9m 6% $0.53m

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