financial assets and liabilities
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8/14/2014
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FINANCIAL ASSETS AND LIABILITIES
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 1
IntroductionLearning outcomesExplain what financial instruments are Define financial instruments in terms of
financial assets and financial liabilitiesDistinguish between the categories of
financial instrumentsDistinguish between debt and equity
capitalAccount for compound instruments 214/08/2014
FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39)
Introduction Learning outcomes Account for issue of equity shares & payment
of equity dividends Account for the issue of redeemable
preference shares and payment of preferenceshare dividends
Understand the recognition, Presentation anddisclosure of financial instruments
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Accounting standards IAS 32 Financial instruments: presentation IAS 39 Financial instruments: recognition
and measurement IFRS 7 Financial instruments: disclosures IFRS 9 Financial instrumentsNote :IFRS 9 was issued in 2009 and is
effective January 2015 but earlier adoptionis permitted will eventually replace IAS 39&32
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Definition of Financial instrumentA financial instrument is any
contract that gives rise to afinancial asset of one entity and afinancial liability or equity onanother entity e.g.
Bonds ,stocks and derivativeinstruments
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Definition of financial asset A financial asset is any asset that has: A contractual right to receive cash or another
financial asset from another entity A contractual right to exchange financial
assets/liabilities with another entity underconditions that are potentially favorable
An equity instrument of another entityE.G Trade receivables(note), Options,
Investment in equity shares. Investment inBond, or loans
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Definition of financial liability A financial liability is any liability that is a
contractual obligation: To deliver cash or another financial asset to another
entity, or To exchange financial instruments with another
entity under conditions that are potentially unfavorable, or
That will or may be settled in the entity’s own equityinstruments.
E.g. trade payables, Bonds, Debenture loans,Redeemable preference shares
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Definition of financial liability/asset
A 'contract' need not be in writing, but itmust comprise an agreement that has 'cleareconomic consequences' and which theparties to it cannot avoid, usually becausethe agreement is enforceable in law.
There should be a contractual obligationto receive cash or another financialinstrument
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ExamplesWhen a company borrow a loan or sells
a Bond that's a financial liabilityWhen a company lends out a loan or
buys a Bond that's a financial asset
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Question to think aboutWhich of the following are financial
Assets /liabilities1. inventories, 2. property, plant and equipment3. Investment in ordinary shares4. Prepayment for goods or service5. Income tax liability
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Solution1. Inventory :no present or contractual right
to receive cash2. property, plant and equipment; Control
of physical assets creates an opportunity to generate an inflow of cash or other assets, but it does not give rise to a present right to receive cash or other financial asset
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Solution3.Investment in ordinary shares; Yes there
is contractual obligation and it is an instrument of another entity.
4. Prepayment for goods or service. No future economic benefit is goods or service not a financial asset
5. Income tax liability. No it is a statutory not contractual obligation.
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Classification of financial instruments
Classified in to 21. Asset /liability instruments2. Equity instruments
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Classification of financial instruments(asset/liability)
A financial liability has a contractual obligation:to deliver cash or another financial asset to another
entity, or to exchange financial instruments withanother entity under conditions that are potentially unfavorable, or
A financial asset has a contractual right toreceive cash or another financial asset from anotherentity, or to exchange financial instruments withanother entity under conditions that are potentiallyfavorable
Eg Bonds ,loans ,redeemable preference shares
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 14
Classification of financial instruments(equity)
An equity financial instrument does not give rise to a contractual obligation/ right
Although the holder of an equity instrument may be entitled to receive dividends , the holder cannot under law force the issuer to declare dividends, so the issuer does not have a contractual obligation to make such distributions
E.g. common stoke and preference shares Note: redeemable preference shares are classified as a
liability because the issuer has a contractual obligation to deliver cash to the order on the redemption date.(if the company bought then its in asset
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Recognition of financial instruments
An entity recognize a financial asset or a financial liability in the statement of financial Position when, and only when, it becomes a party to the contractual provisions of the instrument.
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Derecognition of financial asset/liability
Asset when, and only when, thecontractual rights to the cash flows of thefinancial asset have expired
Liability when, and only when, theobligation specified in the contract isdischarged, cancelled or expires
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Measurement of financial instrument
How the instrument is measured depends on its classificationa liability /asset or equity
We will start with Liabilities then assets and conclude with a equity
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Measurement of financial Liability all financial Liabilities are initially
measured at fair value. This is likely to be the purchase consideration received for the financial liability less issue costs
Fair value =Cost –discount –issue costsTransaction costs/gains are expensed to the
income statement
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Subsequent measurement of financial liability
Liabilities incurred for speculative purposesare measured at fair value any gains/losses are taken to the income statement
All other liabilities are measured atamortised cost using the effectiveinterest rate method
Examples of liabilities include, loanspayable and deep discount bonds
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Amortised cost methodMethod used to calculate how much should
be charge to income statement and in thestatement of Financial position
Amortised cost=Initial cost + interest-repayments
Interest is charged at the effective rateNote: Financial management principles
needed to apply this method
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Reminders BAC 331 features of debt
Par value or nominal value=the principleamount or the face value of the bond/loan
Effective interest rate=the periodicinterest rate charged for the debt
Coupon payment =periodic paymentmade toward the interest
At maturity =par value should be paidtogether with the interest outstanding
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Reminders BAC 331 features of debt
Debt can be at discount ,par or premiumDiscount means fair value amount received
is less than face valuePar means amount received is equal to face
valuePremium means amount received is greater
than face value
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Reminders BAC 331 features of debt
ExampleA K2, 500 8 % bond debt is redeemable at
K3, 125. The debt will mature after 5 years. The effective rate of interest is 10%
What is the annual rate of interest to be charged
What is the annual rate of interest to be paid
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Reminders BAC 331 features of debt
Solution annual rate of interest to be charged is 10%
of the Of outstanding amount (not fixed) annual rate of interest to be paid is 8% of
par value (fixed) 2,500 X 0.08 =200
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Amortised cost methodMethod used to calculate how much should be
charge to income statement and in the statementof Financial position
Amortised cost=Initial cost + interest-repayments
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ExampleA company issues 4% loan notes with a nominal
value of K100, 000. The loan notes are issued at a discount of 2.5% and K2, 670 of issue costs are incurred. The loan notes will be repayable at a premium of 10% after 5 years. The effective rate of interest is 7%.
a)What amount will be recorded as a financial liability when the loan notes are issue
b)What amounts will be shown in the income statement and statement of financial position for years 1 – 5?
c) Show the journal entries for (a)and (b)
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Solution
a)Liability initially recorded at fair valueFair Value =Cost –discount-issue costCost =100,000Discount=2,500(100,000 x 0.025)Issue cost K2,670 Fair Value =100,000-2,500-2670
K 94,830
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Solution B)Amount to be shown in income statementYear Opening Finance Cash paid 4% Closing
costs 7%
1 94,830 6,638 (4,000) 97,4682 97,468 6,822 (4,000) 100,2903 100,290 7,020 (4,000) 103,3104 103,310 7,232 (4,000) 106,542
5 106,542 7,457 (4,000)(110,000) 0
Note the balance at year 5 would have been (110,00) which is repaid as principle
If interest is paid at the beginning subtract from the opening balance then calculate the finance charge
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Solution Finance cost are charged to the income statement The closing balance is the liability in the statement of
financial positionYear Finance cost(i/s) Non-current
liabilities(SFP)1 6,638 97,468
2 6,822 100,2903 7,020 103,3104 7,232 106,5425 7,457 0
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Solution Journal entries a)when loan is issued
Dr Crcashbook 94,830
N.C.Liability 94,830
During the years(1-5)Finance Charge as calculatedN.C.Liability as calculated
Payments(year 1-5)N.C.Liability 4,000Cash book 4,000loan Repayment year 5N.C.Liability 110,000Cash book 110,000
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Example 2A company issues 0% loan notes at theirnominal value of K20, 000. The loan notes arerepayable at a premium of K5, 900 after 3 years.The effectiverate of interest is 9%.a)What amount will be recorded as afinancial liability when the loan notes areissued?
b)What amounts will be shown in thestatement of profit or loss and statement offinancial position 1 -3-?
c)Show the journals for (a) and (b)14/08/2014
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Solutiona)Liability initially recorded at fair valueFair Value =Cost –discount-issue costCost =20,000Discount=0Issue cost =00 Fair Value =K20,000
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solution B)Amount to be shown in income statement
Year Opening Finance Cash paid 0% Closingcosts 9%
1 20,000 1,800 (0) 21,800
2 21,800 1,962 (0) 23,762
3 23,762 2,138 (0)(25,900) 0
The loan notes are repaid at par i.e. K20, 000, plus a premium of K5, 900 at the end of yea 3.
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Solution When the loan notes are issue:
Dr cash book K20,000Cr Loan notes K20,000
During the years(1-3)Finance Charge as calculatedN.C.Liability as calculated
loan Repayment year 3N.C.Liability 25,900Cash book 25,9000
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Preference shares Redeemable preference shares are classified as
a liability because the issuer has a contractualobligation to deliver cash to the order on theredemption date.(if the company bought thenits in asset
Irredeemable preference shares are classified asequity
Redeemable shares are initially measure at fairvalue and subsequent at amortised cost if notheld for resale
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example On 1 April 2007, a company issued 80,000 K1
redeemable preference shares with a coupon rate of 8% at par. They are redeemable at a large premium which gives them an effective finance and cost of 12% per annum.
How would these redeemable preference shares appear in the financial statements for the years ending 31 March 2008 and 2009?
Show the journal entries
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 37
Solution Annual payment =80,000 x K1 x 8% = K6,400 Period Opening Finance Cash Closing
ended balance cost paid balance
31 March @ 12% @8%
2008 80,000 9,600 (6,400) 83,200
2009 83,200 9,984 (6,400) 86,784
i/s SFP
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Solution Journals1. When stock is issued
Dr cash book K80,000Cr Ncliability K80,000
2. Finance charge during the periodDr interest expense amount calculated
Cr Ncliability amount calculated3Cash payment
Dr Ncliability 6400 (per year)Cr Cash book 6400
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 39
Measurement of Financial assets all financial assets are initially measured at
fair value. This is likely to be the purchase consideration paid to acquire the financial asset
Transaction costs are expensed to the income statement
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 40
Subsequent measurement of financial assets
Subsequent measurement depends uponwhether the financial asset is an investmentheld for Speculative(sale) or to hold it tillmaturity
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 41
Subsequent measurement of financial assets
Assets can be measured using either of the following methods.
1. Fair value method-based on the consideration received or given( any gain /losses are taken to income statement)
2. Amortised
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Amortised cost methodThe amortised cost = initial cost + interest-
repayments. The interest will be charged at the effective rate. This
is the internal rate of return of the instrument
Amortised cost is only used if the 2 test are met
1.The business model test 2.Contractual cash flow characteristics test
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 43
The business model test This test establishes whether the entity holds
the financial asset to collect the contractual cash flows or sell the financial asset prior to maturity to realize changes in fair value.
If its to collect the cash flows then the asset has passed this test and the amortized cost method can be used
IF its for sell the fair value should be used
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 44
The contractual cash flow characteristics test
This test determines whether the contractualterms of the financial asset give rise to cashflows on specified dates that are solely ofprincipal and interest based upon theprincipleamount outstanding.
.If this is not the case, the test is failed and thefinancial asset cannot be measured atamortised cost but at fair value.
EG convertible bonds have a right to convert thebond to equity so don’t qualify
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Example A company invests K5, 000 in 10% loan notes. The loan
notes are repayable at a premium after 3 years. The effective rate of interest is 12%. The company intends to collect the contractual cash flows which consist solely of repayments of interest and capital and have therefore chosen to record the financial asset at amortised cost.
What amounts will be shown in the income statement and statement of financial position for the financial asset for years 1 -3?
Show the journal entries
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 46
SolutionYear Opening Investment Cash Closing
Income 12% received 10%1 5,000 600 (500) 5,1002 5,100 612 (500) 5,212 3 5,212 625 (500)
(5,337) 0
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SolutionJournals
1. When loan is givenDr asset (investment) K5,000
Cr Cash book K5,000
2. Investment income during the periodDr Asset(investment ) amount calculated
Cr investment income amount calculated3Cash payment
Dr Cash book 5,000 (per year)Cr Asset(investment ) 5,000
4 Final receipt repaymentDr cash book 5,337Cr Asset(investment ) 5,337
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Measurement of Equity instrument
The equity instruments are measured depends on whether they are held for trading or as an investment (not for trading)
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Measurement of Equity instrument held for trading
Measured at Fair value through Income statement
This means that equity instrument is always recorded at market value in the statement of financial position
The difference between original price and the market price is taken to the income statement under investment income
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 50
Measurement of Equity instrument not held for trading
Measured at Fair value through other comprehensive income
Other comprehensive income is income and expenses that are not recognized in the income statement but are recorded in reserves
This means that equity instrument is always recorded at market value in the statement of financial position
The difference between original price and the market price is taken to the reserves in the statement of comprehensive income
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 51
Example (2) A company invested in 10,000 shares of a listed
company in November 2007 at a cost of K4. 20 per share. At 31 December 2007 the shares a market value of K4.90. The company is planning on selling these shares in April 2008.Prepare extracts from the statement of profit or loss for the year ended 31 December 2007 and a statement of financial position as at that date.
Show the journal entries
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solutionThis an investment held for trading purposes as the
company plans to sell these shares. The investment should therefore be measured at fair value through income statement.
Statement of profit or lossInvestment Income (10,000 x (4.90 – 4.20)) 7,000
Statement of Financial PositionCurrent assetsInvestments (10,000 x 4.90) 49,000
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Solution JournalsInitial investmentDr investment in equity K42,000 (4.2 x 10,000)Cr cash book K42,000Change in market valueDr investment in equity 700((4.9-4.2)x10,000)Cr investment income 700Note if the price has gone down the asset is cr and
investment expense Dr
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Example 2 A company invested in 20,000 shares of a listed
company in October 2007 at a cost of K3.80 per share. At 31 December 2007 the shares have a market value of K3.40. The company is not planning on selling these shares in the short term.Prepare extracts from the statement of profit or loss for the year ended 31 December 2007 and a statement of financial position as at that date
Show the journal entries
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 55
Solution The investment is a financial asset at fair value
through through other comprehensive income. Statement of profit or loss Revaluation reserves (20,000 x (3.40 – 3.80)) (8,000)
Statement of Financial PositionNon-current assetsInvestments (20,000 x 3.40) 68.000
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Solution JournalsInitial investmentDr investment in equity K76,000 (3.8 x 20,000)Cr cash book K76,000Change in market valueCr investment in equity 8000((3.4-3.8)x20,000)Dr Revaluation reserves 8000Note if the price has gone up the asset is Dr and
Reserves Cr
14/08/2014FINANCIAL ASSETS AND LIABILITIES(IFRS 7,IFRS9,IAS 32,39) 57
Offsetting financial assets/financial liabilities
Off setting not allowed except when the entity
Has a legally enforceable right to set off the amounts, and
Intends either to settle on a net basis or to realize the asset and settle the liability simultaneously
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Compound instruments This is a financial instrument that has
characteristics of both equity and liability .E.g. debt that can be converted into shares like convertible bonds
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Compound instruments IAS 32 required compound financial
instruments be split into their componentparts:
A financial liability (the debt)An equity instrument (the option to convert
into shares).These must be shown separately in the
financial statements.14/08/2014
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Compound instruments how to split and record
Step 1Calculate liability component first by finding the value of
the bond( present value of future cash flows assuming non-conversion)Apply discount rate equivalent to interest on similar non-convertible debt instrument (i.e. discount the cash flows at the market rate of interest)
Step 2Calculate the equity component by
deducting the present value of the debt from the proceeds of the issue
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Compound instruments how to split and record
Step 3 Basing on the amortized cost method ,and using
the amount of liability found as the openingbalance calculate amounts to be recorded inincome statement and statement of financialposition
Step 4Calculate the conversion amount basing on
information givenNote use financial management principles on
calculating present value(time value of money )14/08/2014
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Reminders BAC 331 present valuePresent Value is the current value of the
future sum discounted back to the present at an appropriate interest rate.The process of finding the present
value is called discounting
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Reminders BAC 331 present valuePV= FV or PV = FV = ( 1+r)- n
(1+r) n
discount factor
PV is the present value to be calculated FV is the future value given r is the interest rate n is the number of periods interest is earned
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Reminders BAC 331 present valueExampleBarclays bank issues 2500o 5% loan that
attracts interest rate of 10 % and is repayable in full after three years.
What is the present value of the loan?
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Reminders BAC 331 present value Solution
( 1+r)- n Fv X discount factor
Year Cash Discount factor Present valueflow
1 1,250 ( 1+0.1)- 1 =0.909 1,250X0.909=1,136
2 1,250 ( 1+0.1)- 2 =0.826 1,250X0.826=1,033
3 1,250 ( 1+0.1)- 3 =0.751 1,250X0.751=939 3 25000 (1+0.1)-3 0.7513 25000X0.751=18,775
PV=1,136+1033+939+18,782=21,890
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Reminders BAC 331 present value alternative
PV = a 1- (1+r)-n + Par(1+r)-n
r
PVA is present value of an annuity to be calculateda is the installment payment/receiptr is the interest raten is number of periods interest is given
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Reminders BAC 331 present value
PV = 1,250 1- (1.1)-3 +25000(1+0.1)-3
0.1 3,108.56+18,782.87 21,891.43
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Example compound instrumentA company issues 2% convertible bonds at their nominal
value of K36, 000.
The bonds are convertible at any time up to maturity into 120 ordinary shares for each K100 of bond. Alternatively the bonds will be redeemed at par after 3 years.
Similar non-convertible bonds would carry an interest rate of 9%.
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Example compound instrumentThe present value of K1 payable at the end of year, based on rates of
2% and 9% are as follows:
End of year 2% 9%1 0.98 0.922 0.96 0.843 0.94 0.77
What amounts will be shown as a financial liability and as equity when the convertible bonds are issued?
What amounts will be shown in the income statement and statement of financial position for years 1 – 3?
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SolutionStep 1 Calculate liability componentCash flow = 2% x 36,000 = 720 YearCash f low Discount factor 9%Present value 1 720 0.92 662.4 2 720 0.84 604.8 3 720 0.77 554 .4
3 36,000 0.77 27,72029,541.6
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solution Calculate the equity componentproceeds of the issue-liability component
36,000- 29,541.6=6,458
Journal entryWhen the convertible bonds are issued:
Dr Bank K36, 000Cr Financial Liability K29,542Cr Equity K6,458
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Solution Step 3 measurement of liability amortized costYear Opening Finance Cash paid 2% Closing
costs 9%1 29,542 2,65 (720) 31,4812 31,481 2,853 (720) 33,5943 33,594 3,023 (720)
(36,000) 0I/S SFP
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Solution Step 4 Calculate the conversion of bondCaring amount as at end of year 3Equity 6,458Bond 36,000
42,458120 ordinary shares for each K100 of bond.
X shares for 36,000 bond( 120X 36,000) /100
=43,200The difference between the Caring amount and the
conversion amount is recorded as either discount or premium 42,458-43,200=742 discount
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Interest dividends ,loses and gains The accounting treatment of interest and
dividends depends upon the accounting treatment of the underlying instrument itself. E.g.
Equity dividends declared are reported directly in equity
Dividends on redeemable preference shares classified as a liability are an expense in the income statement .
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Disclosure Disclosure must be made for each type of financial
instrument (Liability ,asset or equity) gains expenses and losses should be shown
appropriately
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Any questions
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