Dap An Ke Toan Quoc Te 2 Ueh

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.
3 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.
4 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.
5 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
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-for-
sale 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
2
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No Further Distribution Or Reproduction Permitted
Advanced Financial Accounting
Chapter 9 solutions
instruments that are intended to be held to maturity.

* determining fair value for all financial instruments could be costly.
9
(a) No. The availability to the holder of the option to convert is inconsistent with
the presumed intention of holding to maturity.
(b) Yes. The call option to the issuer, if exercised, merely alters the
maturity date of the instrument.
(c) No. Holding for an indefinite period does not demonstrate intent to hold to
maturity.
(d) No. Reits are not debt instruments.
10
(a) Yes.
(b) No. The sale is effected very near to the date of maturity.
(c) No. The dispose was in response to a significant deterioration
in the credit worthiness of the issuer.
(d) Yes; other securities in the portfolio are similarly ‘tainted’.
(e) Yes, at the group level.
11
(a) The implementation of IAS 32 could be costly in the following ways:
1) 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.
2) 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.
3) Direct costs of accounting for compound financial instruments will also increase –
the need to prepare amortization schedule, determine the effective cost of debt, etc.
(b) 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 $1,312,810

Present value of principal at maturity 7,811,984
$9,124,794
Discount on bond (also = to equity component) $ 875,206
Amortisation schedule of bond discount

Coupon Effective Amortisation Unamortized Carrying
Date interest interest Of bond Bond value of bond
discount Discount
(a) (b) C = b -a
1/1/x0 $875,206 9,124,794
30/6/x0 150,000 228,120 78,120 797,086 9,202,914
31/12/x0 150,000 230,073 80,073 717,013 9,282,987
30/6/x1 150,000 232,075 82,075 634,939 9,365,061
31/12/x1 150,000 234,127 84,127 550,812 9,449,188
30/6/x2 150,000 236,230 86,230 464,582 9,535,418
31/12/x2 150,000 238,385 88,385 376,197 9,623,803
30/6/x3 150,000 240,595 90,595 285,601 9,714,399
31/12/x3 150,000 242,860 92,860 192,742 9,807,258
30/6/x4 150,000 245,181 95,181 97,560 9,902,440
31/12/x4 150,000 247,560 97,560 0 10,000,000
Superior Corporation
Balance sheet (adjusted)
As at 31.12.20x2
Non-current assets 20,000,000

Current assets 8,000,000
28,000,000
Current liabilities 6,000,000

Non-current liability 9,623,803
15,623,803
Share capital 10,000,000

Retained earnings 1,500,991 (Note a)
Cap. Reserves –equity option 875,206
28,000,000
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Note (a):
Retained earnings (unadjusted) 2,000,000
Less amortized bond discount:
20x0 (158,193)
20x1 (166,202)
20x2 (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
Coupon Effective Amortisation Unamortized Carrying

value of
Date Interest interest of bond Bond bond
Discount discount
(a) (b) c = b –a
1/1/x0 $875,206 9,124,794
30/6/x0 150,000 228,120 78,120 797,086 9,202,914
31/12/x0 150,000 230,073 80,073 717,013 9,282,987
30/6/x1 150,000 232,075 82,075 634,939 9,365,061
31/12/x1 150,000 234,127 84,127 550,812 9,449,188
30/6/x2 150,000 236,230 86,230 464,582 9,535,418
Partial conversion of 30% of Bond -139,375 -2,860,625
31/12/x2 105,000 166,870 61,870 263,337 6,736,663
30/6/x3 105,000 168,417 63,417 199,920 6,800,080
31/12/x3 105,000 170,002 65,002 134,918 6,865,082
30/6/x4 105,000 171,627 66,627 68,291 6,933,373
31/12/x4 105,000 173,291* 68,291 0 7,000,000
Superior Corporation
Equity section of balance sheet (proforma)
As at 31.12.20x2
Shareholders’ equity:
Share capital 13,123,187 (Note a)
Retained earnings 1,572,506 (Note b)
Cap. Reserves 612,644 (Note c)
Total equity 15,308,337
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Notes:
(a) Share capital at 1/1/20x2 10,000,000
30% of carrying value of bond converted 3.123.187
13.123.187
(b) Retained earnings

Unadjusted balance 2,000,000
Interest for 20x2 saved (net of tax) 45,000*
Amortized bond discount
20x0 (158,193)
20x1 (166,202)
20x2 (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 3,123,187
(Record conversion of 30% of bond)
31/12/20x2
Dr Amortization of discount 61,870
Cr Cash 105,000
(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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Chapter 9 solutions
Bond amortization schedule

Carrying
Cash Effective Amortized Unamortized value of
Date Interest Interest Discount discount bond
01-01-x0 1,312,810 8,687,190
30-06-x0 100,000 217,180 117,180 1,195,630 8,804,370
31-12-x0 100,000 220,109 120,109 1,075,521 8,924,479
30-06-x1 100,000 223,112 123,112 952,409 9,047,591
31-12-x1 100,000 226,190 126,190 826,219 9,173,781
30-06-x2 100,000 229,345 129,345 696,874 9,303,126
31-12-x2 100,000 232,578 132,578 564,296 9,435,704
30-06-x3 100,000 235,893 135,893 428,404 9,571,596
31-12-x3 100,000 239,290 139,290 289,114 9,710,886
30-06-x4 100,000 242,772 142,772 146,341 9,853,659
31-12-x4 100,000 246,341 146,341 - 0 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 = $9,760,865

Carrying value of debt 01/07/x2 = 9,303,126
Difference $457,739
The carrying value of debt and equity components is as follows:
Carrying values of:

Debt component 9,303,126
Equity component 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 Bond redemption expense 457,739*
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Chapter 9 solutions
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 = $1,019,964
FV = $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

= $85,000 x 3.465106 + $1,000,000 x 0.792094
= $1,086,628
Fair value of bond at 31.12.20x2

= $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) 1,019,964
Cr Cash 1,019,964
(Record investment in bond)
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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Chapter 9 solutions
Dr Investment 70,067
Cr Deferred gain -Equity 70,067
(Adjust fair value of bond: [$1,086,628 – $1,019,964 + $3,403])
Coupon Effective Amortization Unamortized Bond carrying

Interest interest of bond
Date (8.5%) (8%) premium bond premium Value
31.12.20x0 19,964 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
[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) 438,126
(Sale of 40% of bonds: $1,095,316 x 0.4))
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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Chapter 9 solutions
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
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 12,100
(Dividends declared: 10,000 x 1.21)
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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Chapter 9 solutions
Problem 9.5
(1) Effective interest rate

Per half- year 1.0587% Per annum 2.1174%
(2) Amortization table
Date Cash Effective Amortization Unamortized Principal Carrying Fair

interest interest premium amount value
1.5% per 1.0587%
half-year per half-year
01-Jul-06 500,000 12,000,000 12,500,000
31-Dec-06 180,000 132,338 47,663 452,338 12,000,000 12,452,338 $11,510,266
30-Jun-07 180,000 131,833 48,167 404,170 12,000,000 12,404,170 $11,139,584
31-Dec-07 180,000 131,323 48,677 355,493 12,000,000 12,355,493
30-Jun-08 180,000 130,808 49,192 306,301 12,000,000 12,306,301
31-Dec-08 180,000 130,287 49,713 256,588 12,000,000 12,256,588
30-Jun-09 180,000 129,760 50,240 206,348 12,000,000 12,206,348
31-Dec-09 180,000 129,229 50,771 155,577 12,000,000 12,155,577
30-Jun-10 180,000 128,691 51,309 104,268 12,000,000 12,104,268
31-Dec-10 180,000 128,148 51,852 52,416 12,000,000 12,052,416
30-Jun-11 180,000 127,584 52,416 0 12,000,000 12,000,000
1,800,000 1,300,000 500,000
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Chapter 9 solutions
(3) Fair value of MRPS
31-Dec-06
Prevailing interest rate 2% per half-year
Fair value (present value) $11,510,266

Payment 180,000
Periods 9
Future value 12,000,000
30-Jun-07
Prevailing interest rate 2.5% per half-year
Fair value (present value) $11,139,584

Payment 180,000
Periods 8
Future value 12,000,000
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Chapter 9 solutions
(4) Income Statement effects

(a) HTM (b) AFS (c) FVTPL
31-Dec-06
Interest income 132,338 132,338 132,338
Fair value adj ($942,072)
132,338 132,338 -809,734
(Journal entries are not required but are useful)
Dr Cash 180,000 180,000 180,000
Cr MRPS 180,000 47,663 47,663
Cr Interest income 132,338 132,338 132,338
Dr Fair value loss $942,072

Cr MRPS $942,072
Dr Deferred loss (equity) $942,072

Cr MRPS $942,072
30-Jun-07
Interest income 131,833 131,833 131,833
Loss in fair value ($322,515)
131,833 131,833 -190,682
(Journal entries are not required but are useful)
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Chapter 9 solutions

Dr Cash 180,000 180,000 180,000
Cr Unamortized premium 48,167
Cr MRPS 48,167 48,167
Cr Interest income 131,833 131,833 131,833
Dr Fair value loss $322,515

Cr MRPS $322,515
Dr Deferred loss $322,515

Cr MRPS $322,515
(5) Balance sheet effects

31-Dec-06
Assets
MRPS 12,452,338 $11,510,266 $11,510,266
Cash -12,320,000 -12,320,000 -12,320,000
132,338 -809,734 -809,734

Equity
Deferred loss (AFS) ($942,072)
P&L 132,338 132,338 -809,734
132,338 -809,734 -809,734
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Chapter 9 solutions
31-Dec-07
Assets
MRPS 12,404,170 $11,139,584 $11,139,584
DCash -12,140,000 -12,140,000 -12,140,000
264,170 -1,000,416 -1,000,416
Equity
Deferred loss (AFS) ($1,264,587)
DP&L 131,833 131,833 -190,682
Beginning RE 132,338 132,338 -809,734
264,170 -1,000,416 -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 Unamortized Principal Carrying

interest interest discount amount
1.0% per Principal amount:
half-year per half-year
01-Jul-06 -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

Cr Cash 120,000
Cr Unamortized discount 51,700
(4) 50% of the MRCPS is converted on 31 Dec 20x8
Dr Equity options (50% * 1,053,331) 526,666

Dr Debt 6,000,000
Cr Unamortized discount on debt 143,480 (includes rounding up)
Cr Issued share capital 6,383,186
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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 Cash 10,000,000
Dr Unamortized bond discount 1,622,179
Cr Bond payable 10,000,000
Cr Capital reserve - Equity 1,622,179
31/12/20x1
Dr Amortization of bond discount 140,517
Cr Cash 200,000
Cash Effective Amortization Carrying value

interest interest expense of bond
1/1/20x1 8,377,821
30/6/20x1 200,000 335,113 135,113 8,512,934
31/12/20x1 200,000 340,517 140,517 8,653,451
1/1/20x3

Dr Debt settlement expense (P/L) 506,708
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Chapter 9 solutions
Cr Cash 9,458,281
Cr Unamortized discount on bond 1,048,427
(To recognise the repurchase of the liability component.)
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 12,000
Cr Interest income – Bond A 7,000
Cr Interest income - Bond B 5,000
(Record cash interest income on bonds)
Dr Interest income 840

Cr Held-to-maturity – Bond A 840
(Amortization of bond premium: see table below)
Amortisation Unamortized Carrying
Coupon Effective of bond bond Value of
Date 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’]
20
Chapter 9 solutions
Problem 9.9
31 October 20x4

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 $800,000

Fair value of revised note:
PV of interest receivable in 20x3 $23,148
PV of interest receivable in 20x4 $21,433
PV of principal of $500,000 $428,669
PV of future cash flows from note 473,251
Impairment loss ($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)

Cr Note receivable 326,749
(Record impairment loss on note receivable)
31 December 20x3
Dr Cash 25,000
Dr Note receivable 12,860
21
Chapter 9 solutions

(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 25,000
Dr Note receivable 13,889
(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 Carrying
interest interest interest Premium amount
1 Jan 2010 75,255 2,675,255
30 Jun 2010 39,000 26,752 12,248 63,007 2,663,007
31 Dec 2010 39,000 26,631 12,369 50,638 2,650,638
30 Jun 2011 39,000 26,507 12,493 38,145 2,638,145
31 Dec 2011 39,000 26,382 12,618 25,527 2,625,527
30 Jun 2012 39,000 26,256 12,744 12,783 2,612,783
31 Dec 2012 39,000 26,128 12,872 -89 2,600,000
(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) 3,640,000
Dr Unamortized premium (75,255*1.4) 105,357
Dr Equity Options purchased (324,745*1.4) 454,643
Cr Cash (3,000,000*1.4) 4,200,000
30 Jun 2010 Coupon interest settlement

Dr Cash (39,000*1.38) 53,820
Dr Exchange loss 390
Cr Interest income (26,752*1.39) 37,185
Cr Unamortized premium (12,248*1.39) 17,025
31 Dec 2010 Coupon interest settlement

Dr Cash (39,000*1.32) 51,480
Exchange loss on debt carrying amount

Dr Exchange loss 212,916
Cr Investment in Debt Security 212,916
Debt carrying amount in SGD, at 31 Dec 2010 rate (2,650,638*1.32) 3,498,842

22
Chapter 9 solutions
Debt carrying amount in SGD, at actual rate

(3,745,357 – 17,025 – 16,574) 3,711,758
Exchange loss (212,916)

Cr Equity options purchased 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

Dr Cash (39,000*1.2) 46,800

Dr Cash (39,000*1.3) 50,700
Cr Exchange gain 2,340

Cr Investment in Debt Security 54,081

Debt carrying amount in SGD, at actual rate (3,498,843 – 15,616 – 15,961)3,467,266
Exchange loss on equity option

Cr Equity option purchased 6,494

Equity option on 31 Dec 2010 428,663
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
Dr Cash 3,000,000
23
Chapter 9 solutions
Cr Bond issued 2,600,000

Cr Unamortized premium 75,255
Cr Capital reserve – Equity options 324,745

Dr Unamortized premium 12,248
Cr Cash 39,000

Cr Cash 39,000

Cr Cash 39,000

Cr Cash 39,000
(3)(a)
A’s book (no conversion to equity)
30 June 2012 Coupon interest settlement
Dr Cash (39,000*1.28) 49,920
Exchange gain on debt carrying amount

Dr Investment in Debt Security 52,258
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 (3,413,185 – 16,441) 3,396,744
Exchange gain 52,258
Recognition of impairment loss

Dr Impairment loss 3,318,186
Cr Investment in Debt Security 3,318,186
Unadjusted debt carrying amount in SGD, at 31 Dec 2012 rate

(2,612,880*1.28) 3,344,486
Debt FV at 31 Dec 2012 (20,000*1.28) 25,600
Impairment loss in SGD (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
24
Chapter 9 solutions
Cr Investment in debt security 25,600

Cr Equity Options purchased (324,745*1.28) 415,674
Problem 9.12
(1)
Dr FVOCI Debt Security (2,675,255*1.4) 3,745,357
Cr Cash (3,000,000*1.4) 4,200,000

Dr Cash (39,000*1.38) 53,820
Cr FVOCI Debt Security (12,248*1.39) 17,025

Dr Cash (39,000*1.32) 51,480

Cr FVOCI Debt Security 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
Recognition of FV change in OCI

Dr Deferred loss (OCI) 198,842
Debt carrying amount in USD, at 31 Dec 2010 rate (2,650,638*1.32) 3,498,842

Debt FV at 31 Dec 2010 (2,500,000*1.32) 3,300,000
Deferred loss in SGD 198,842



Dr Cash (39,000*1.2) 46,800
25
Chapter 9 solutions

Dr Cash (39,000*1.3) 50,700


Recognition of FV change in OCI

Dr Deferred loss (OCI) 549,342
Debt carrying amount in SGD, at 31 Dec 2011 rate

(3,300,000 – 15,616 – 15,961 – 54,081) 3,214,342
Debt FV at 31 Dec 2011 (2,050,000*1.3) 2,665,000
Deferred loss in SGD 549,342



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)
Dr Cash (39,000*1.28) 49,920

Dr FVOCI Debt Security 53,766
Cr Exchange loss 53,766
26
Chapter 9 solutions

Reclassification of deferred loss

Cr Deferred loss (OCI) 748,312
Recognition of impairment loss

Dr Impairment loss 2,676,225
Cr FVOCI Debt Security 2,676,225

(2,665,000 – 16,441+ 53,766) 2,702,325
Debt FV at 31 Dec 2012 (20,000*1.28) 25,600
Impairment loss in SGD (2,676,725)
(b)
Same as (a), in addition assume fair value of equity securities is the same as fair value of debt security
and equity option purchased
Problem 9.13
(1)
Dr Trading Debt Security (2,675,255*1.4) 3,745,357
Cr Cash (3,000,000*1.4) 4,200,000

Dr Cash (39,000*1.38) 53,820
Cr Trading Debt Security (12,248*1.39) 17,025

Dr Cash (39,000*1.32) 51,480

Cr Trading Debt Security 212,916

Debt carrying amount in SGD, at actual rate
(3,745,357 – 17,025 – 16,574) 3,711,758
27
Chapter 9 solutions
Recognition of FV change in P/L

Dr Fair value gain/loss - trading debt 198,842
Debt carrying amount in USD, at 31 Dec 2010 rate (2,650,638*1.32) 3,498,842

Debt FV at 31 Dec 2010 (2,500,000*1.32) 3,300,000
Fair value loss in SGD 198,842



Dr Cash (39,000*1.2) 46,800

Dr Cash (39,000*1.3) 50,700


Recognition of FV change in P/L

Dr Fair value gain/loss - trading debt 549,342
Debt carrying amount in SGD, at 31 Dec 2011 rate

(3,300,000 – 15,616 – 15,961 – 54,081) 3,214,342
Debt FV at 31 Dec 2011 (2,050,000*1.3) 2,665,000
Fair value loss in SGD 549,342


28
Chapter 9 solutions

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)
Dr Cash (39,000*1.28) 49,920

Dr Trading Debt Security 53,766
Cr Exchange loss 53,766

Recognition of fair value loss

Dr Fair value gain/loss – trading debt 2,676,225
Cr Trading Debt Security 2,676,225

(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)
Same as (a), in addition assume fair value of equity securities is the same as fair value of debt
security and equity option purchased
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 748,312
Cr Deferred loss (OCI) 748,312
Reclassify unamortized premium of debt security

29
Chapter 9 solutions
Problem 9.15
A’s book (reclassification from FVTPL to amortized cost)
1 Jan 2012
Reclassify unamortized premium of debt security
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.
30
Advanced Financial
Accounting
Solutions Manual
Chapter 10
Accounting for Derivatives and Hedge Accounting

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-of-
the-money. His potential gain could exceed his potential loss if the option expires in-
the-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.
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 $1,800
Less loss on intrinsic value (500)
Net gain on put option $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 $70,000
From 1 October to 31 December 20x5 ($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 ($900,000)
[FC10,000,000 x (1.23 – 1.32)]
Change in fair value of forward contract $800,000
[FC10,000,000 x (1.33 – 1.25)
Net gain(loss) ($100,000)
3
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.

PROBLEMS
Problem 10.1
(1) Assessment of hedge effectiveness
Change in value of Change in fair value of

inventory based on spot futures contract
price of gold
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 190,000
[To record loss on futures contract]
5
Dr Inventory 200,000
Cr Gain on inventory 200,000
[To record gain in fair value of inventory
Dr Cash 250,000
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)
31 Mar 30 April 31 May
Notional amount 100,000 100,000 100,000

Spot price of oil $42 $45 $44
Strike price $40 $40 $40
Premium/unit $3 $6 $4
Fair value of option $300,000 $600,000 $400,000
Intrinsic value $200,000 $500,000 $400,000
Time value $100,000 $100,000 $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 200,000
Cr Cash 200,000
(Record purchase of call option)
31 March 20x3
Cr Hedging reserves – equity 200,000
(Effective portion (intrinsic value) taken to equity)
Dr Loss on time value 100,000

Cr Call option 100,000
(Time value expensed to income)
3 April 20x3
Cr Hedging reserves – equity 300,000

31 May 20x3
Dr Hedging reserves – equity 100,000
Dr Loss on time value 100,000

(Time value expensed to income)
Dr Purchase of jet fuel oil/inventory 4,400,000

Cr Cash 4,400,000
(Purchase of jet fuel oil)
Dr Hedging reserves – equity 400,000

Cr Purchase of jet fuel oil/inventory 400,000
(Adjust effective portion of the hedge against cost of inventory)
Dr Cash 400,000
( Close position on call option)
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 Dr Put option 500

firm commitment Cr Cash
500
[Purchase of put option]
30.6.20x2 30.6.20x2
Dr Loss on firm Dr Put Option 500

Commitment (P/L) 500 Cr Gain on put option (P/L)
Cr Firm commitment 500
500 [Gain in intrinsic value of put option]
[To record loss in fair value of firm
commitment] Dr Loss on put option (P/L) 300
Cr Put Option
300
[Loss on time value of put option]
7
31.7.20x2 31.7.20x2
Dr Loss on firm Dr Put option 500

Commitment (P/L) 500 Cr Gain on put option 500
Cr Firm commitment 500 [Gain in intrinsic value of put option]
[To record loss in fair value of firm
commitment]
Dr. Investment 5,000 Dr Loss on put option 200

Cr Cash 5,000 Cr Put option
[Purchase of Fastrack shares for $5,000] 200
[Loss in the time value of put option]
Dr. Firm commitment 1,000
Cr. Investment 1,000
[Transfer loss from firm commitment to Dr Cash 1,000
investment ] Cr Put option 1,000
(Close put option contract)
Dr Cash 4,000
Cr Investment 4,000
(Sale of Fastrack shares).
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 Time Intrinsic

Notional Premium value value value
Date amount per FC of option of option 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 - 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.

(2) Journal entries
1 March 20x3
Dr Put option 22,500

Cr Cash/bank 22,500
(Purchase of put option)
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 Loss on firm commitment 15,000

Cr Firm commitment 15,000
Dr Accounts receivable 850,000

Cr Sales 850,000
(Record delivery of equipment)
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

(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 10,000
(Record exchange loss on accounts receivable)
Dr Cash 840,000
Cr Accounts receivable 840,000
(Record settlement of accounts receivable)
9
Dr Cash 35,000
Cr Put option 35,000
(Net settlement of put option)
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

(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).

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)

Cr Cash 358,400
(Purchase of available-for-sale investment)
1 November 20x4
Dr Fair value reserves – equity 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 Forward contract 11,400
Dr Exchange loss on investment 12,000
Cr Gain on forward contract 11,400
(Record change in fair value of investment attributable to change in stock price and
change in foreign exchange rate:

Fair value of investment at 1/11/20x4 $356,250

Fair value of investment at 31/12/20x4 363,000
Change in fair value $6,750
Attributable to:
Change in share price only* $18,750
[100,000 x 1.25 x ($3.00 – 2.85)
Change in foreign exchange rates (12,000)
[100,000 x 3 x ($1.21 - $1.25)
$ 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 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 $ 363,000

Fair value of investment at 31/03/20x5 $ 351,600
Change in fair value ($11,400)
Attributable to:
Change in share price ($8,470)
[100,000 x 1.21 x ($2.93 – 3.0)
Change in foreign exchange rates ($2,930)
[100,000 x 2.93 x ($1.20 - $1.21)
($ 11,400)
Change in fair value of forward contract:
285,000 x (1.21 – 1.20) = $2,850
Dr Cash 8,550
11
(Settle forward contract at maturity date on a net basis)
Dr 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

(Record change in fair value of put option in income)
Dr Loss on investment (AFS) 9,600

(Record change in fair value of investment attributable to price change)

(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 18,150
(Close position on put option)
Dr Cash 344,850
Cr Investment 344,850 (Liquidate
available-for-sale investment: 100,000 x 2.85 x 1.21)
Dr Fair value reserves (equity) 19,450

Cr Gain on hedging 19,450
(Transfer cumulative fair value adjustments from equity to income).

Summary:
Investment at cost $358,400

Sale proceeds 344,850
Loss on investment ($13,550)
Allocated to:
Equity 19,450
Income (33,000)
Allocated to:
Change in FV of AFS Equity 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)
Transfer 8,470 (8,470)
30/06/20x5 (6,750) 2,850 (9,600)
(13,550) 19,450 (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

FV of Change Change
Notional Current Contracted Current Fwd in Change in in
spot Fwd FV of spot time
Date Amount rate Fwd rate rate contract Fwd element value
FC000 $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

13
Notional
Amount Current Expected Change in
Cashflow Expected CF
Date FC000 spot rate ($000) ($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
(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

(Record:
 defer effective portion (spot component) to equity)
30 March 20x2

(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).


Cr Gain on firm commitment 400,000
(Record change in fair value of firm commitment)
Dr Cash 16,900,000
Cr Sales 16,900,000
(Record recognition of sales revenue)
Dr Hedging reserve 900,000

Cr Sales 500,000
(Transfer/adjust effective portion of cash flow hedge and firm commitment against
sales revenue).
Dr Cash 100,000
(Settlement of forward contract on a net basis).
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 Time value (Interest component) (I/S) 200,000
(Record:
 defer effective portion (spot component) to equity.)
Dr Cash 16,900,000
Cr Sales 16,900,000
(Record recognition of sales revenue)

Cr Sales 500,000
(Transfer/adjust effective portion of cash flow hedge and firm commitment against
sales revenue).
Dr Cash 100,000
(Settlement of forward contract on a net basis).
15
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 Current Fair value of Change in fair

Spot Fwd Notional Discount fwd value of
Date Rate Fwd rate rate Amount Factor contract fwd. contract
30.9.20x5 2.915 2.98 2.98 $0 $0 $0
31.12.20x5 2.937 2.98 2.969 100,000 1.0150751* (1,084) (1,084)
31.1.20x6 2.92 2.98 2.9269 100,000 1.010025 (5,257) (4,174)
31.3.20x6 2.931 2.98 2.931 100,000 1 (4,900) 357
*(1.06)^3/12
Cum.
Change Period to Period to period Period to period
in spot period change in Cum. Change in change in change in fair value
Date element spot element 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


(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*

(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 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 357
(To record change in fair value of forward contract)

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.
Period to
Notional Discount period change
17
Amount Current Cum. Factor PV of in PV of

FC000 Change change expected CF
Fwd Expected in expected in expected
Date rate Cashflow cash flows cash flows
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

(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
(To record the change in fair value of forward contract directly to equity).
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)

(To record change in fair value of forward contract)

Cr Cash 4,900
(To record settlement of the forward contract on a net basis).

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 Change
Fair value in in Change in
of FV of
Notional Spot Forward forward fwd spot interest
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
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

(Record change in fair value of firm commitment based on spot rate)
Dr Accounts receivable 17,000,000

Cr Sales 17,000,000
19
(Record delivery and sales)
Dr Firm commitment 1,400,000

Cr Sales 1,400,000
(Adjust firm commitment against sale)
1 April 20x2
Dr Bank 17,600,000
Cr Accounts receivable 17,000,000
(Settlement of accounts receivable and record exchange gain on
accounts receivable)

(Record loss on forward contract)
Dr Cash 400,000
(Settlement of forward contract on a net basis)
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:
Fair Change
Spot Contract Current Notional Discount value of in FV of Spot Interest
Fwd fwd.
Date Rate Fwd rate rate amount Factor contract fwd element Element
30/6/x1 1.072 1.077 1.077 $0 - - - -

(1.005)^6=
31/12/x1 1.08 1.077 1.082 100,000 1.0303775 485 485 776 (291)
(1.005)^3=
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)

Period to
Cum. PV of period
Notional Current Change Discount change change
Amount Fwd Expected in expected Factor in expected in PV of
Date FC000 rate Cashflow cash flows cash flows expected CF
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
Cr Cash 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

Cr Hedging reserve (equity) 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

Cr Hedging reserve 254
Cr Payable 108,300
Dr Hedging reserves 739

Cr Inventory 739
21
[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 Payable 108,300
Cr Cash 108,700
[To record exchange loss on payable ($1.087 – 1.083)*100k and settlement of the payable]

Dr Cash 1,000
(2) 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) 291

Cr Equity (spot element) 776
(Please refer table in part (1) above)
[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) 54

Cr Equity (spot element) 308
(see table in part (a) above)
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.]

30/6/20x2 Dr Exchange loss 400

Dr Payable 108,300
Cr Cash 108,700

Dr Cash 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.
Time value not excluded Time value is excluded

B/S: Carrying value of inventory $107,561 $107,216
Income Statement 0 (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:
Change
Spot Notional Discount FV of firm 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
23
Change in Change in FV Change in Change in FV

FV of firm of firm FV of fwd of fwd contract
commitment commitment contract (Cumulative)
(Period-to (Cumulative) (Period-to
Date period) period) Delta ratio
30/6/x1
31/12/x1 776 776 776 776 1
31/3/x2 308 1,084 308 1,084 1
30/6/x2 416 1,500 416 1,500 1
(1) Journal entries
31/12/20x1
Dr Loss on firm commitment 776

Dr Interest portion 291
Cr Forward contract 291
31/3/20x2
Dr Loss on firm commitment 308


Dr Interest portion 54
Cr Forward contract 54
Cr Payable 108,300
Cr Inventory 1,084
30/6/20x2

Dr Payable 108,300
Cr Cash 108,700

Dr Cash 1,000
(2)
Cash flow hedge Fair value hedge

Inventory @ 31/3/x2 107,216 107,216
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 Fixed Floating Net Fair Change in

+ rate rate receipts value of fair value of
Date 150 bp payments receipts (payments) swap swap
1/1/20x3
30/06/20x3 5.5% 1,375,000 1,375,000 576,573 576,573
31/12/20x3 6.0% 1,375,000 1,500,000 125,000 929,275 352,702
30/6/20x4 6.5% 1,375,000 1,625,000 250,000 492,637 (436,637)
31/12/20x4 6.2% 1,375,000 1,550,000 175,000 238,838 (253,800)
30/6/20x5 6.0% 1,375,000 1,500,000 125,000 72,816 (166,022)
31/12/20x5 5.8% 1,375,000 1,450,000 75,000 0 (72,816)
30 June 20x3
Dr Interest expense 1,375,000

Cr Bank 1,375,000
(Payment of interest on floating rate loan)
Dr Interest rate swap 576,573

Cr Fair value adjustment (equity) 576,573
(Record change in fair value of swap)
31 December 20x3

Cr Bank 1,500,000
25
Dr Bank 125,000
Cr Interest receipt 125,000
(Receipt of swap differential)
Dr Interest rate swap 352,702

Cr Fair value adjustment (equity) 352,702
30 June 20x4

Cr Bank 1,625,000
Dr Bank 250,000
Dr Fair value adjustment (equity) 436,637

Cr Interest rate swap 436,637
31 December 20x4

Cr Bank 1,550,000
Dr Bank 175,000

30 June 20x5

Cr Bank 1,500,000
Dr Bank 125,000

31 December 20x5

Cr Bank 1,450,000
Dr Bank 75,000

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.
Hedged item 1/10/x1 31/12/x1 28/2/x2 31/3/x2

Spot price of silver coin $3.30 $3.27 $3.15 $3.10
Quantity 5,000,000 5,000,000 5,000,000 5,000,000
Expected cash flows 16,500,000 16,325,000 15,750,000 15,500,000
Change in expected cash
flows -175,000 -575,000 -250,000
Futures contract
Exercise price $3.21 $3.17 $3.05 $3.00
FV of futures contract $200,000 $800,000 $1,050,000
Period-to-period hedge effectiveness assessment
Gain (loss) on
expected
Gain (loss) on 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
Hedge effectiveness assessment on a cumulative basis
Cumulative Cumulative
Gain (loss) Gain(loss)
on futures on expected Hedge
Date Contract cash flows Ratio
31/12/20x1 200,000 -175,000 1.14
28/2/20x2 800,000 -750,000 1.06
31/3/20x2 1,050,000 -1,000,000 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 Futures contract 200,000 [(3.21 – 3.17) x 5,000,000]

Cr Profit or loss 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 Futures contract 600,000 [(3.17 – 3.05) x 5,000,000]

Cr Profit or loss 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.]

31 March 20x2

[Effective portion in the change in the fair value of the futures contract is taken to equity;
there is no ineffective portion]
Dr Cash 15,500,000
Cr Sales 15,500,000
Dr Cost of sales 15,000,000

Cr Inventory 15,000,000
Dr Hedging reserve 1,000,000

Cr Sales 1,000,000
[To ‘recycle’ hedging reserve against sale.]
Dr Cash 1,200,000
Cr Margin deposit 150,000
Cr Futures contract 1,050,000
[Close position on futures contract]
(3)
Without hedging With hedging
Sales 15,500,000 16,500,000

COGS (15,000,000) (15,000,000)
Gross profit 500,000 1,500,000
Gain on futures contract __________ 50,000
Net profit $500,000 $1,550,000
Problem 10.14
(1) Journal entries
The journal entries are based on the following computations:
Hedged item 1/10/x1 31/1/x1 28/2/x2 31/3/x2

Spot price of silver coin $3.30 $3.265 $3.15 $3.10
Quantity 5,000,000 5,000,000 5,000,000 5,000,000
Fair value of inventory 16,500,000 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)
Options contract
Premium $0.12 $0.13 $0.175 $0.20
Exercise price $3.30 $3.30 $3.30 $3.30
29
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
Delta ratio 1 1 1
1/10/x1
Dr Option contract 600,000

Cr Cash 600,000
Purchase of option contract
31/12/x1
Dr Loss in fair value of inventory 175,000

Record change in the fair value of the inventory
Dr Loss in time value of option 125,000

Cr Options contract 125,000
Record loss in time value of the option contract
Dr Options contract 175,000

Cr Gain in intrinsic value 175,000
Record gain in intrinsic value of the option contract
28/2/x2



31/3/x2




Dr Cash 1,000,000
Cr Option contract 1,000,000
Close option position
Dr Cash 15,500,000
Cr Sales 15,500,000
Sale of inventory
Dr Cost of sales 14,000,000

Cr Inventory 14,000,000
(2)
Without hedging With hedging
Sales 15,500,000 15,500,000

COGS (15,000,000) (14,000,000)
Gross profit 500,000 1,500,000
Net gain on option contract 400,000
Loss on inventory (1,000,000)
Profit $500,000 $900,000
Problem 10.15
Transaction 1: Fair value hedge
31 July 30 Sept
20x5 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 - 28,000
Time value $3,000 $0
Delta ratio 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
Journal entries:
31 July 20x5
Cr Cash 250,000
(Investment in AFS)
Dr Put option 3,000

Cr Cash 3,000
(Purchase of put option)
30 September 20x5
Dr Loss on fair value (AFS) 30,000
Change in fair value of AFS
Dr 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 28,000
(Close option position)
Transaction 2: (Cash flow hedge)
Journal entries:
31 March 20x5
Cr Cash/bank 900,000
Interest expense for the quarter ended 31 March
Dr Swap asset 666,273

Cr FV adjustment (equity) 666,273
Change in fair value of swap
30 June 20x5
Cr Cash/bank 1,000,000
Interest expense for the quarter ended 31 March
Dr Cash/bank 100,000
Cr Interest expense 100,000
Net settlement at end of June quarter
Dr Swap asset 477,931

Cr FV adjustment (equity) 477,931
Change in fair value of swap
30 September 20x5
Cr Cash/bank 1,100,000
Dr Cash/bank 200,000
Cr Interest expense 200,000
Dr FV adjustment (equity) 470,697

Cr Swap asset 470,697
Transaction 3: Hedge of net investment
Fair value Change

Spot Contracted Current Notional of in Spot Interest
Fwd Fwd FV of
Date Rate Fwd rate rate amount contract fwd element Component
$’000 $’000 $’000 $’000 $’000
1/1/x5 1.8 $0 $0 $0 $0 $0
31/3/x5 1.785 1.78 1.77 2,240 22.4 $22.4 33.6 (11.20)
30/6/x5 1.765 1.78 1.755 2,240 56.0 $33.6 44.8 (11.20)
30/9/x5 1.75 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 Interest component (P/L) 11,200
Cr FCTR (Equity) 33,600
30 June 20x5

33
30 September 20x5

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 (30,000)

Gain on put option 25 ,000
Interest expense (2,700,000)
Interest component of
forward contract (26,880)
Balance sheet
Equity
FV Adjustment (swap) 673,507
Assets
Available-for-sale 220,000
Forward contract 85,120
Swap asset 673,507
Equity
FCTR 112,000*

* 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 SGD/USD forward Time value
maturing 30 June 2011
1 January 2010 1/1.40=0.7143 1/1.37=0.7299 0.7299-0.7143 =0.01564
30 June 2010 1/1.38=0.7246 1/1.36=0.7353 0.7353-0.7246=0.01066
31 December 2010 1/1.32= 0.7576 1/1.29=0.7752 0.7752-0.7576=0.0176
30 June 2011 1/1.20=0.8333 1.20=0.8333 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 46,200
Cr Firm commitment (payable) 46,200
Dr Forward contract (0.7752-0.7353)*S$1.4m 55,860

Cr Gain on forward contract (P/L) 55,860
Dr Equipment (0.7576*S$1.4m) 1,060,640

Cr Equipment payable 1,060,640
Dr Deferred gain (OCI) 14,420

Dr Firm commitment (payable) 46,200
Cr Equipment 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 89,740
Cr Equipment payable (0.8333-0.7692)*S$1.4m 89,740
Dr Equipment payable 1,166,620

Cr Cash (US$1.4m x 0.8333) 1,166,620
Dr Forward contract (0.8333-0.7752)*S$1.4m 81,340

Cr Gain on forward contract (P/L) 81,340
Dr Cash (0.8333-0.7299)*S$1.4m 144,714

(Cash settlement locked in forward rate of 0.7299)
35
31 Dec 2011
Depreciation for equipment
Dr Depreciation expense (1,076,880-76,860)/10 100,002
Cr Accumulated depreciation – Equipment 100,002
Problem 10.17
Swap interest settlement table (notional principal US$3,000,000) (figures in USD)
Date Libor + Rec float Pay fixed Net Period to Swap asset Change
1% 1.5% receipt/ maturity (liability) swap
(payment) asset
1 Jan 1.5% 0
2010
30 Jun 1.75% 45,000 45,000 0 5 (1) 36,536 36,536
2010
31 Dec 1.46% 52,500 45,000 7,500 4 (2) -4,714 -41,250
2010
30 Jun 1.40% 43,800 45,000 (1,200) 3 (3) -8,876 -4,162
2011
31 Dec 1.78% 42,000 45,000 (3,000) 2 (4) 16,578 25,454
2011
30 Jun 53,400 45,000 8,400 1
2012
31 Dec
2012
(1) PV(i=1.75%/2, PMT=3750, n=5) = 7,500*4.8714 = 36,536

(2) PV(i=1.46%/2, PMT=-600, n=4) = -1,200*3.9281 = -4,714
(3) PV(i=1.40%/2, PMT=-1500, n=3) = -3,000*2.9585 = -8,876
(4) PV(i=1.78%/2, PMT=4200, n=2) = 8,400*1.9736 = 16,578
30 June 2010
Dr Swap Asset/Liability 50,420
Cr Swap fair value P/L (36,536*1.38) 50,420
31 Dec 2010
Dr Cash (7,500*1.32) 9,900
Cr Swap interest income (7,500*1.32) or (7,500*1.34) 9,900
Swap interest receipt
Dr Swap fair value P/L (41,250*1.32) 54,450

Cr Swap Asset/Liability 54,450
Swap fair valuation on 31 Dec 2010
30 Jun 2011
Dr Swap interest income (1200*1.2) (or 1200*1.25) 1,440
Cr Cash 1,440
Dr Swap fair value P/L (4,162*1.2) 4,994

Cr Swap Asset/Liability 4,994

31 Dec 2011
Dr Swap interest income 1,950
Cr Cash (3,000*1.30) 1,950
Swap interest receipt
Dr Swap Asset/Liability 33,090

Cr Swap fair value P/L (25,454*1.30) 33,090
Swap fair valuation on 31 Dec 2011
37
Advanced Financial
Accounting
Solutions Manual
Chapter 11
Accounting for Taxes on Income

Advanced Financial
Accounting
Solutions Manual
Chapter 12
Earnings per Share

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
No Further Distribution or Reproduction Permitted
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
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 9,250,000

Add: assumed conversion of preference shares [750,000* x 5/2 ] 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
= $2,500,000 - $240,000*
6,166,667**
= 36.65 cents
*$5,000,000 x 0.048
** Number of shares after bonus issue = 9,250,000

Bonus issue (9,250,000/3) (3,083,333)
No. of shares before bonus 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
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) = 36.65 cents x 2/3 = 24.43 cents

(Alternatively: $2,260,000/9,250,000)
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
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 15,000,000
Diluted earnings per share = 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) $ 842473
PV of principal $7,472,582
$8,315,054
Effective interest for 20x3 = $8,315,054 x 0.06 = $498,903
Less tax @ 20% (99,780)
Interest (net of tax) saved $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).
5
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
6
(2) Calculation of basic earnings per share
Basic EPS = Net profit attributable to ordinary shareholders

Net profit for 20x3 $12,800,000

less preference dividends ( 320,000)*
Profit attributable to ordinary shareholders $12,480,000
* 4,000,000 x $5 x 6.4% x 3/12
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 = $3,800
1,000 rights shares @ $1 1,000
3,000 ord shares $4,800
Ex-rights price = $4,800/3,000 = $1.60
EPS (20x3) = $12,480,000/26,875,000
= 46.44 cents
7
Calculation of profit attributable to ordinary shareholders for 20x4:
Net profit after tax $14,500,000
Less preference dividends:

First two quarters* (640,000)
Next two quarters** (480,000)
Profit attributable to ordinary shares $13,380,000
* On 4 million preference shares

** On 3 million preference shares
Shares in Bonus Time Weighted number

Date issue issue weightage of shares (000)
1.1.20x4 30,000 2 3/12 15,000
1.4.20x4 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) = $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 $8,000,000

Less preference dividends (1,200,000 x 0.68) (816,000)
Net profit attributable to ordinary shares $7,184,000
Basic earnings per share = $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]) 166,667
Add: ordinary shares to be issued on assumed conversion of pref. Shares 2,400,000
22,566,667
8
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 $7,000,000

less preference share dividends (0.08 x 6,000,000) (480,000)
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)

less preference share dividends (0.08 x 1,000,000) (80,000)
$2,720,000
Loss from discontinued operation ($1,500,000)
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) 30,000,000

Conversion of preference shares 5,000,000
Exercise of warrants (2,500,000 x 3/6) 1,250,000
9
Basic EPS (20x1 – full year)

less preference share dividends (560,000)
$9,240,000
Weighted average number of shares (Note b) 33,125,000
Basic EPS (full year):

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
Diluted earnings per share (20x1 – first half)

less preference share dividends 0*
*no dividend as all preference shares are assumed to be converted at beginning of year.

Plus incremental shares on:
Assumed conversion of preference shares 6,000,000
Assumed exercise of warrants (Note c) 348,837
Adjusted weighted average number of shares 36,348,837
Diluted EPS (first half) = $7,000,000/36,348,837 = 19.26 cents
Note (c):
Proceeds from exercise: $4 x 5,000,000 = $20,000,000
Proceeds /Average price of $4.30 = 4,651,163 shares
No. of shares deemed issued a nil = 5,000,000 – 4,651,163 = 348,837
10
Diluted earnings per share (20x1 – second half)

Less preference share dividends (0)
$2,800,000
Weighted average number of shares (Note d) 37,852,837
Note (d): Calculation of weighted average number of shares

Plus incremental shares on:
Assumed conversion of pref. Shares 1,000,000
Assumed exercise of warrants ( Note e) 602,837
Adjusted weighted average number of shares 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 = 2,083,333 shares
No. of shares deemed issued at nil 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 = 2,127,660 shares
No. of shares deemed issued at nil 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
11
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)

Less preference share dividends (0)
$9,800,000
Weighted average number of shares (Note f) 37,159,421
Diluted earnings per share (20x1):

Loss from discontinued operations (-$1,500,000/37,159,421) = (4.04) cents
Profit 22.33 cents
Note (f)
Number of shares at 1 Jan 20x1 30,000,000

Conversion of pref. Shares 6,000,000
Conversion of warrants :
Actual conversion of warrants: 2,500,000 x 3/12 625,000
Assumed conversion (Note g) 534,421
Total 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) = 326,087
Total 534,421
12
Problem 12.6
Basic EPS = Net profit attributable to ordinary shareholders

Net profit after tax $2,800,000

Less pref dividend (240,000) [4.8% x $5,000,000]
Net profit attributable to ordinary shareholders $2,560,000
Number of shares outstanding/issued
At 1.1.20x3 20,000,000
At 1.4.20x3 - 1 for 4 bonus issue 5,000,000
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
Net Loss = [-$200,000 – $240,000]/25,000,000
= - 1.76 cents
Calculation of diluted EPS (20x3)
Net profit for basic EPS $2,560,000
Add: Preference dividends 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].
13
Weighted average number of shares for diluted EPS:
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 Denominator EPS
Effect Effect
As per basic EPS 2,560,000 25000000 10.24 cents
Add convertible bonds 153,916(a) 2,750000
2,713,916 27,750,000 9.78 cents
Add Pref shares 240,000 3,125,000
2,953,916 30,875,000 9.57 cents
Diluted earnings per share (discontinued operation)
= -$3,000,000/30,875,000
= -9.72 cents
Diluted earnings per share (net) = ($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.
14
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
Carrying
Cash interest Effective Amortisation Unamortised value
Date 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
15
Weighted average number of shares:
No. of shares Bonus issue in RI Fraction of year Weighted No of shares
1.1.20x4 25,000,000 2/1.7 (Note b) 3/12 7,352,941
1.4.20x4 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
Add contingently issuable shares (adjusted for bonus issue):

Entitlement under agreement 100,000
Adjustment for bonus issue in 20x3 (1 for four) 25,000
Adjustment for bonus element in rights issue in 20x4 22,059 147,059
(125,000 000 x [2/1.7 – 1]) 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
16
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 Denominator
Effect Effect EPS
As per basic EPS 3,496,176 39,850,000 8.77 cents
Add: share options ________ 636,364 (e)
3,496,176 40,486,364 8.64 cents
Add convertible bonds 249,536(f) 3,300000 (g)
3,745,712 43,786,364 8.55 cents
Add Pref shares 303,824 2,426,470(h)
4,049,536 46,212,834 8.76 cents
Diluted EPS (20x4) = 8.55 cents (convertible preference shares are antidilutive)
17
Notes:
(e) Shares deemed issued at nil under share options
No of potential ordinary shares 2,000,000 @ $1.50 = $3,000,000
No. of shares deemed issued at nil [2,000,000 - $3,000,000/$2.20]= 636,364
(f) Interest on bond:

$10,000,000 x 0.02 x 6/12 $ 100,000
$ 6,000,000 x 0.02 x 6/12 60,000
Amortisation expense ($94,243 + $57,677) 151,920
$311,920
Tax @ 20% ( 62,384)
Effective interest net of tax $249,536
(g) Assumed conversion of convertible bonds
Assumption: all convertible bonds converted at 1.1.20x4
Number of shares issued on assumed 100% conversion 5,500,000

[10,000,000 x 550/1000]
Less number of shares issued on actual conversion during year -2,200,000
Additional number of shares 3,300,000
(h)
Number of ordinary shares based on original conversion ratio 2,500,000

[5,000,000 x 500/1,000]
Add: Adjustment for 1-for-4 bonus issue 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
18
(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
Net Loss = [-$200,000 – $240,000]/(25,000,000 x 2/1.7)
= - 1.50 cents
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
19
Problem 12.7
Time
Basic EPS for 20x2 Increase in Add bonus Cumulative Period weight Weighted
Date Item Ordinary shares issue balance outstanding average shares
1/1/20x2 Balance at start 5,000,000 5,000,000 10,000,000 1 Jan – 30 April 4/12 3,333,333
1/5/20x2 Share repurchase (1,200,000) (1,200,000) 7,600,000 1 May - 1 Oct 6/12 3,800,000
1/7/20x2 Bonus issues 3,800,000
1/11/20x2 Issue of new shares 900,000 8,500,000 1 Nov - 31 Dec 2/12 1,416,667
31/12/20x2 Balance at year-end 8,500,000 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
Profit attributable to ordinary
Weighted average shares shareholders Basic EPS
Basic EPS for 20x2 8,550,000 5,020,000 $0.5871
20
Increase in
ordinary shares
from assumed
Convertible preference shares Units conversion
Issued on 1 April 20x2 4,000,000 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 8,550,000
Incremental number of shares on assumed conversion of preference shares 6,000,000
14,550,000
Weighted
Profit attributable to ordinary average
shares shares Diluted EPS
Diluted EPS for 20x2 5,200,000 14,550,000 $0.3573
21
Problem 12.8
Time
Basic EPS for 20X2 Increase in Add shares Cumulative Period weight Weighted
Date Item ordinary shares from split balance outstanding average shares
1/1/20X2 Balance at start 2,000,000 2,000,000 4,000,000 1 Jan - 31 Mar 1/4 1,000,000
1/4/20X2 Issue of new shares 400,000 400,000 4,800,000 1 Apr - 1 Oct 1/2 2,400,000
1/8/20X2 Share split 2,400,000
1/10/20X2 Conversion of pref shares 450,000 5,250,000 1 Oct - 31 Dec 1/4 1,312,500
31/12/20X2 Balance at year-end 5,250,000 4,712,500
Profit attributable to OS WA shares Basic EPS

Basic EPS for 20x2 $6,846,750 4,712,500 $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 337,500 (450000*9/12)
(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 550,000 (550,000 x 12/12)
Incremental shares arising from assumed conversion as at 1 Jan 20X2 887,500
Impact on profit attributable to ordinary shareholders from assumed conversion:

22
Avoidance of dividends declared on preference shares during 20X2 53,250
Earnings per Incremental Share 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 0

Earnings Per Incremental Share 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 5%
Savings of interest expense (after-tax) on convertible bonds: 120,000 5%*6000000*1/2*80%
Earnings Per Incremental Share 0.040
23
Ranking by EPIS (EPIS) EPIS

(1) Stock Options 0.00 Most dilutive
(2) Convertible Bonds 0.040
(3) Convertible Preference Shares 0.0600 Least dilutive
Determination of Diluted EPS

Weighted
Profit average DEPS
number of shares
Basic EPS 6,846,750 4,712,500 1.452891
Include effects of assumed exercise of options 0 60,000
Aggregate DEPS 6,846,750 4,772,500 1.434625 Dilutive
Include effects of assumed conversion of convertible bonds 120,000 3,000,000
Include effects of assumed conversion of preference shares 53,250 887,500
Reported DEPS (20X2) 0.810624

24
Problem 12.9
(Parts 1, 2 and 3 are reflected on this section)
20x1
Net profit after tax 7,000,000

Preference dividends (30,000) 1/2*6%*1000000
Net profit attributable to ordinary shareholders 6,970,000
20x1
(Part 1 and 2) Restated 20x1 (Part 3) 20x2
Basic EPS 3.49 (Note 1) 1.74 (Note 3) 1.452891

Diluted EPS 3.11 (Note 2) 1.56 (Note 4) 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)
25
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 Number of shares
Shares in issue 2,000,000

Less: Treasury shares (500,000) x 12/12 (500,000)
1,500,000
Shares repurchased on 31 March 20x6 (50,000)x 9/12 (37,500)
Shares repurchased on 30 September (60,000)x 3/12 (15,000)
20x6
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
26
Advanced Financial
Accounting
Solutions Manual
Chapter 13
Share-based Payment

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 share-
based 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
2
(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 market-
related condition which is normally tied to the market price of the firm’s shares or a share
index.
3
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
4
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
Dr Expense
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
Dr Expense
Group (Cash-settled)
Dr Expense
Cr Liabilities
5
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
6
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 76,667
Cr Share options reserve 76,667
(Recognition remuneration expense : 100,000 options x $2.30 x 1/3)
31 May 20x5
(Recognition remuneration expense : 100,000 options x $2.30 x 2/3 - $76,667)
31 May 20x6
(Recognition remuneration expense : 100,000 options x $2.30 - $153,333)
(2) 1 June 20x6
Dr Cash 300,000
Cr Share option reserves 230,000
Cr Share capital 530,000
(Record exercise of share options by chief executive officer and increase in share capital)
7
Exercise 13.4
Journal entries:
31 December 20x1
Dr IPO expense 83,333
Cr Equity reserve 83,333
(Record receipt of services under an equity-settled share-based payment arrangement:

$500,000/6 months)
31 May 20x2
Dr IPO expense 416,667
Cr Equity reserve 416,667
(Record receipt of services under an equity-settled share-based payment arrangement:

$500,000 - $83,333)
Dr Equity reserve 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 Current period Cumulative expense

expense
31.12.20x1 100 x 10,000 x 0.95 x $1.50 x $475,000 $475,000
1/3
31.12.20x2 (100 x 10,000 x 0.95 x$1.50 x $475,000 $950,000
2/3) – $475,000
31.12.20x3 100 x 10,000 x .94 x $1.50 - $460,000 $1,410,000
$950,000
(2) Journal entries
31 December 20x1
Cr Share option – reserve 475,000
(Record share option expense for 20x1)
31 December 20x2
8
31 December 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 Expense Equity Liability

$ $ $
20x1 Liability component:
(10,000 × $3.50 × 10 x 1/3) 116,667 116,667
Equity component:
($8,000 × 1/3) 2,667 2,667
(10,000 × $4 × 10x 2/3) – $116,667 150,000 150,000
Equity component:
($8,000 × 1/3) 2,667 2,667
(10,000 × $5 x 10 – $266,667 233,333 233,333
Equity component:
($8,000 × 1/3) 2,666 2,666
End 20x3 Scenario 1: cash paid to settle liability ($500,000)

Scenario 1 totals 508,000 508,000 0
Scenario 2: 110,000 shares issued 508,000* (500,000)
Scenario 2 totals 508,000 508,000 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:
9
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
Cr Share option reserves (equity) 2,667
Cr Liability 116,667
(Record share option expense)
31 December 20x2
31 December 20x3
Under Scenario 1 (Employees chose cash alternative):
31 December 20x3
Dr Liability 500,000
Cr Cash 500,000
(Settlement of liability under share-based compensation plan)
Under Scenario 2 (Employees chose equity alternative):
31 December 20x3
Dr Share option reserves (equity) 8,000
(Settlement of liability under share-based compensation plan by issue of shares)
10
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 Cumulative
period expense
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
200,000 exercised options × ($1.20 – $1.10)
20x5 100,000 exercised options × ($1.25 – $1.20) 5,000 110,000
31 December 20x1
Cr Share option reserve – equity 8,400
(Record share-based payment expense for 20x1)
31 December 20x2
31 December 20x3
11
31 December 20x4
Dr Cash (200,000 x 0.85) 170,000
Dr Share option reserve - equity 70,000
(200/300 x 105,000)
(Record exercise of 200,000 options at end of 20x4)
31 December 20x5
Dr Cash (100,000 x 0.85) 85,000
Dr Share option reserve – equity 40,000
(100/300 x 105,000 + 5,000)
(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).
12
(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
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.
(100,000 shares x $3) - $200,000 = $100,000

Adjustment in fair value of liability (20,000)*
Remuneration expense for 20x4 $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 = $280,000
Allocated between:
Equity $ 30,000
Liability $250,000
$280,000
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.
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.
(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.
100,000 share options x $5 - $500,000 = $0
31 December 20x1
(Record remuneration expense for 20x1.)
31 December 20x2
31 December 20x3 No journal entry is recorded as remuneration expense is nil.
Problem 13.6
Year Computations Expense Equity

20x1
Remuneration expenses for year:
100,000 shares options × 95 × $0.80 x ½ 3,800,000 3,800,000
20x2 Remuneration expenses for year: 3,560,000 3,560,000
14
(100,000 shares × 92 × $0.80) – $3,800,000

Journal entries:
31 December 20x1
Dr Remuneration expense 3,800,000
Cr Share option reserve – equity 3,800,000
31 December 20x2
Dr Remuneration expense 3,560,000
Cr Share option reserve – equity 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
(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
(100,000 shares options × 10 × $2) - $1,300,000 = $700,000.
31 December 20x1
31 December 20x2
15
31 December 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 4,000,000
(Record exercise of options)
16
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 Computations Current period expense Cumulative liability
20x1 20 x 10,000 x 0.95 x $4 x 1/3 $253,333 $253,333
20x2 (20 x 10,000 x 0.95 x $3.50 x 2/3) – $190,000 $443,333
$253,333
20x3 (18 x 10,000 x $4.50) - $443,333 $366,667 $810,000
20x4 (8 x 10,000 x $4.20) - $810,000 + -$474,000 + $390,000 = $336,000
10 x 10,000 x $3.90 - $84,000
20x5 8 x 10,000 x $4.30 0 - $336,000 + $344,000 0
=
$8,000
(2) Journal entries
31 December 20x1
(Record remuneration expense and related liability of SARs for 20x1).
31 December 20x2
31 December 20x3
31 December 20x4
Cr Remuneration expense 84,000
Cr Cash 390,000
(Record writing back of remuneration expense and settlement of liability on exercise

of options)
17
31 December 20x5
Cr Cash 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 = 390,000
8 employees x 10,000 SARS x $4.30 344,000
734,000
18

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Advanced Financial

Pearl Tan, Chu Yeong Lim and Ee Wen Kuah

Copyright © 2016 by McGraw-Hill Education (Asia)

1 A mandatorily redeemable preference shares (MRPS) is a preference shares with the

2 A compound financial instrument is a financial instrument with a debt component and

Financial liabilities are categorized into:

instruments that are intended to be held to maturity.

(a) The implementation of IAS 32 could be costly in the following ways:

(b) In what ways may the implementation be beneficial for users of

Implementation of IAS 32 may benefit both informed/sophisticated users as

(c) Why is the FASB’s stand a controversial issue?

12. IAS 39 – Held-to-maturity (HTM), Available for sale (AFS), FVTPL

14. The three categories are:

Key factors in determining expected credit losses:

flows. The prepayment of mortgage backed securities is based on prepayment of underlying

The debt component is calculated as follows:

Present value of 10 semiannual interest payments $1,312,810

Amortisation schedule of bond discount

Non-current assets 20,000,000

Current liabilities 6,000,000

Share capital 10,000,000

(b) 30% of bonds converted

(Note: AG32 On conversion of a convertible instrument at maturity, the entity derecognises

Amortisation schedule with partial conversion

Coupon Effective Amortisation Unamortized Carrying

31/12/x4 105,000 173,291* 68,291 0 7,000,000

(b) Retained earnings

** rounding difference of 1. Taxation is ignored.

(c) Journal entries 20x2

Dr Interest expense 150,000

Dr Capital reserves 262,562

(1) Calculation of fair value of bond:

Bond amortization schedule

(2) Interest expense for 20x1:

Difference between fair value and carrying value of debt component:

Fair value of debt at 01/07/x2 = $9,760,865

The carrying value of debt and equity components is as follows:

Carrying values of:

Dr Bond payable 10,000,000

Cr Unamortized discount 696,874

Dr Capital reserve 539,135

Calculation of fair value of bond:

(1) Fair value at 31/12/20x0 = $1,019,964

FV = $85,000 x PVIFA,8%,5 years + PVF,8%,5 years

Fair value of bond at 31.12.20x1

FV = $85,000 x PVIFA,6%,4 years + PVF,6%,4 years

Fair value of bond at 31.12.20x2

FV = $85,000 x PVIFA,5%,3 years + PVF,5%,3 years

Coupon Effective Amortization Unamortized Bond carrying

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

Dr Dividends receivable 12,100

(1) Effective interest rate

(2) Amortization table

Date Cash Effective Amortization Unamortized Principal Carrying Fair

1,800,000 1,300,000 500,000

(3) Fair value of MRPS

Fair value (present value) $11,510,266

Fair value (present value) $11,139,584