Dap An Ke Toan Quoc Te 2 Ueh
Dap An Ke Toan Quoc Te 2 Ueh
Accounting
An IFRS® Standards Approach, 3e
Solutions Manual
Chapter 9
Financial Instruments: Classification, Recognition and
Measurement
CHAPTER 9
CONCEPT QUESTIONS
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
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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.
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(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.
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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.
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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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.
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.
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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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.
Superior Corporation
Balance sheet (adjusted)
As at 31.12.20x2
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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
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
(c) Capital reserves –equity option remaining is 70% of the original capital reserves
30/6/20x2
31/12/20x2
Dr Interest expense 105,000
Dr Amortization of discount 61,870
Cr Cash 105,000
Cr Unamortized bond discount 61,870
(Record interest expense and amortization of bond discount)
Problem 9.2
(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
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:
Problem 9.3
(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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Dr Investment 70,067
Cr Deferred gain -Equity 70,067
(Adjust fair value of bond: [$1,086,628 – $1,019,964 + $3,403])
31.12.20x2
Dr Cash 85,000
Cr Investment 3,675
Cr Interest income 81,325
[Record interest income and adjustment to bond carrying value. Note: the effective interest is
the effective interest at the date of purchase of the bond.]
Dr Investment 12,363
Cr Deferred gain - Equity 12,363
(Fair value adjustment of investment: [$1,095,316 -$1,082,953])
Dr Cash 438,126
Cr Investment (AFS) 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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Problem 9.4
1 October 20x4
Dr Investment (AFS) 358,400
Cr Cash 358,400
(Investment in Scotts Corporation classified as available-for-sale: 100,000 x 2.8 x
1.28)
31 December 20x4
Dr Investment (AFS) 4,600
Cr Fair value reserves – equity 4,600
[Adjust carrying value of AFS to fair value and change in fair value to equity:
$363,000 - $358,400)
1 March 20x5
Dr Cash 12,050
Dr Exchange loss on dividend 50
Cr Dividends receivable 12,100
(Dividend received and exchange loss on dividend)
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Problem 9.5
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31-Dec-06
Prevailing interest rate 2% per half-year
30-Jun-07
Prevailing interest rate 2.5% per half-year
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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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Assets
MRPS 12,452,338 $11,510,266 $11,510,266
Cash -12,320,000 -12,320,000 -12,320,000
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31-Dec-07
(a) HTM (b) AFS (c) FVTPL
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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Problem 9.6
(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%
(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
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Problem 9.7
(1) Allocate carrying value of bond to debt and equity components
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 Interest expense 200,000
Dr Amortization of bond discount 140,517
Cr Cash 200,000
Cr Unamortized bond discount 140,517
1/1/20x3
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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
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 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.
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Problem 9.9
31 October 20x4
31 December 20x4
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)
(2)
1 January 20x3
31 December 20x3
Dr Cash 25,000
Dr Note receivable 12,860
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31 December 20x4
Dr Cash 25,000
Dr Note receivable 13,889
Cr Interest income 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)
(2)
K’s book
1 Jan 2010 Purchase of convertible bonds
Dr Cash 3,000,000
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(3)(a)
A’s book (no conversion to equity)
30 June 2012 Coupon interest settlement
Dr Cash (39,000*1.28) 49,920
Dr Exchange loss 390
Cr Interest income (26,255*1.29) 33,869
Cr Unamortized premium (12,745*1.29) 16,441
(b)
A’s book (conversion to equity)
Same as (a), in addition assume fair value of equity securities is the same as fair value
of debt security and equity option purchased
Dr Investment in equity security 441,274
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Problem 9.12
(1)
Entries in A’s book in SGD
1 Jan 2010 Purchase of convertible bonds
Dr FVOCI Debt Security (2,675,255*1.4) 3,745,357
Dr Equity Options purchased (324,745*1.4) 454,643
Cr Cash (3,000,000*1.4) 4,200,000
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(3)(a)
A’s book (no conversion to equity)
30 June 2012 Coupon interest settlement
Dr Cash (39,000*1.28) 49,920
Dr Exchange loss 390
Cr Interest income (26,255*1.29) 33,869
Cr FVOCI Debt Security (12,745*1.29) 16,441
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(b)
A’s book (conversion to equity)
Same as (a), in addition assume fair value of equity securities is the same as fair value of debt security
and equity option purchased
Dr Investment in equity security 480,243
Cr Investment in debt security 25,600
Cr Equity Options purchased (324,745*1.4) 454,643
Problem 9.13
(1)
Entries in A’s book in SGD
1 Jan 2010 Purchase of convertible bonds
Dr Trading Debt Security (2,675,255*1.4) 3,745,357
Dr Equity Options purchased (324,745*1.4) 454,643
Cr Cash (3,000,000*1.4) 4,200,000
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(3)(a)
A’s book (no conversion to equity)
30 June 2012 Coupon interest settlement
Dr Cash (39,000*1.28) 49,920
Dr Exchange loss 390
Cr Interest income (26,255*1.29) 33,869
Cr Trading Debt Security (12,745*1.29) 16,441
(b)
A’s book (conversion to equity)
Same as (a), in addition assume fair value of equity securities is the same as fair value of debt
security and equity option purchased
Dr Investment in equity security 480,243
Cr Investment in debt security 25,600
Cr Equity Options purchased (324,745*1.4) 454,643
Problem 9.14
A’s book (reclassification from FVOCI to amortized cost)
1 Jan 2012
Reclassify accumulated deferred loss to investment in debt security
Dr Investment in debt security 748,312
Cr Deferred loss (OCI) 748,312
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Problem 9.15
A’s book (reclassification from FVTPL to amortized cost)
1 Jan 2012
Reclassify unamortized premium of debt security
Dr Unamortized premium (25,527*1.3) 33,185
Cr Investment in debt security 33,185
Problem 9.16
(1)
Loss rate at initial recognition = 90,000/2,000,000 = 4.5%
Loss rate at reporting date = 500,000/2,000,000 = 25%
Increase in expected credit loss = $500,000 - $90,000 = $410,000
(2)
Significant changes in external market indicators of credit risk for a particular financial
instrument or similar financial instrument with the same term. Changes in market indicators
of credit risk include: credit spread, credit default swap prices for borrower, credit ratings,
fair values versus amortized cost, changes in prices of borrower’s credit instrument,
significant changes in operating results of borrower.
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Accounting
An IFRS® Standards Approach, 3e
Solutions Manual
Chapter 10
Accounting for Derivatives and Hedge Accounting
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.
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.
8 A hedge of a net investment is accounted for in a way similar to a cash flow hedge. The
effective portion is taken to equity and the ineffective portion, if any, is taken to income.
Advanced Financial Accounting (Tan, Lim and Kuah)
Chapter 10 Solutions
EXERCISES
Exercise 10.1
The answer is (b). The put option is in-the-money at the maturity date and the option premium
is entirely made up of the intrinsic value which is the exercise price less the market price ($3.60
- $3.55).
Exercise 10.2
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
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
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Note: It is assumed that the forward contract is a fair value hedge of a firm commitment.
Exercise 10.8
Exercise 10.9
Exercise 10.10
Exercise 10.11
PROBLEMS
Problem 10.1
* 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.
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]
31 January 20x6
Dr Loss on futures contract 190,000
Cr Futures contract 190,000
[To record loss on futures contract]
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Chapter 10 Solutions
Dr Inventory 200,000
Cr Gain on inventory 200,000
[To record gain in fair value of inventory
Dr Cash 250,000
Dr Futures contract 80,000
Cr Margin deposit 330,000
[Close futures position]
Note: In practice, the margin deposit requires topping up if it falls below a stipulated level. For
our purpose, the changes in the margin deposit (top-ups, if any) are ignored.
Problem 10.2
(1)
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
Dr Call option 200,000
Cr Hedging reserves – equity 200,000
(Effective portion (intrinsic value) taken to equity)
3 April 20x3
Dr Call option 300,000
Cr Hedging reserves – equity 300,000
(Effective portion (intrinsic value) taken to equity)
31 May 20x3
Dr Hedging reserves – equity 100,000
Cr Call option 100,000
(Effective portion (intrinsic value) taken to equity)
Dr Cash 400,000
Cr Call option 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
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Chapter 10 Solutions
31.7.20x2 31.7.20x2
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:
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.
1 March 20x3
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
28 February 20x4
Dr Cash 840,000
Cr Accounts receivable 840,000
(Record settlement of accounts receivable)
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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:
Problem 10.5
1 November 20x4
Dr Fair value reserves – equity 2,150
Cr Investment (AFS) 2,150
(Record change in fair value of available-for-sale investment in equity:
Fair value of investment at 1 November 20x4 = LC2.85 x 100,000 x $1.25 = $356,250.)
31 December 20x4
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).
31 March 20x5
Dr Fair value reserves – equity 8,470 * reversed out to I/S see last entry
Dr Exchange loss on investment 2,930
Dr Loss on forward contract 2,850
Cr Investment (AFS) 11,400
Cr Forward contract 2,850
(Record change in fair value of investment attributable to change in stock price and change
in foreign exchange rate:
Dr Cash 8,550
Cr Forward contract 8,550
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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 Cash 18,150
Cr Put option 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)
Summary:
Allocated to:
Equity 19,450
Income (33,000)
Allocated to:
Change in FV of AFS Equity Income
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 .
Notional
Amount Current Expected Change in
Cashflow Expected CF
Date FC000 spot rate ($000) ($000)
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 February 20x2
30 March 20x2
Dr Cash 16,900,000
Cr Sales 16,900,000
(Record recognition of sales revenue)
Dr Cash 100,000
Cr Forward contract 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 Cash 16,900,000
Cr Sales 16,900,000
(Record recognition of sales revenue)
Dr Cash 100,000
Cr Forward contract 100,000
(Settlement of forward contract on a net basis).
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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:
*(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
(1) Time value (interest element is excluded from the hedge relationship)
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:
31 December 20x5
31 January 20x6
Dr Inventory 292,000
Dr Hedging reserve 495
Cr Inventory 495
Cr Accounts payable 292,000
(To record purchase of inventory at spot rate and adjust the cumulative effective portion of the
forward contract to the cost of inventory.)
31 March 20x6
(2) Time value (interest element was not excluded from hedge relationship)
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
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Journal entries:
31 December 20x5
31 January 20x5
Dr Hedging reserve -Equity 4,174
Cr Forward contract 4,174
(To record the change in fair value of forward contract directly to equity).
Dr Inventory 292,000
Dr Inventory 5,258*
Cr Hedging reserve 5,258
Cr Accounts payable 292,000
(To record purchase of inventory at spot rate and adjust the cumulative hedging reserve to the
cost of inventory.)
31 March 20x6
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
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).
1 March 20x2
Dr Forward contract 200,000
Cr Gain on forward contract 200,000
(Record change in fair value of forward contact and gain on forward contract.).
1 April 20x2
Dr Bank 17,600,000
Cr Exchange gain 600,000
Cr Accounts receivable 17,000,000
(Settlement of accounts receivable and record exchange gain on
accounts receivable)
Dr Cash 400,000
Cr Forward contract 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
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
The hedge is fully effective as numerator and denominator are based on same forward rates.
Dr Forward contract 0
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
31/3/20x2
Dr Inventory 108,300
Cr Payable 108,300
[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 Cash 1,000
Cr Forward contract 1,000
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
Dr Inventory 108,300
Dr Equity 1,084
Cr Inventory (hedging gain) 1,084
Cr Payable 108,300
[To recognize the purchase of paper at spot rate (1.083 x FC100,000] and to remove the
cumulative gain on spot element of the forward exchange contract that has been recognized
directly in equity and include it in the initial measurement of the purchased paper.]
Dr Cash 1,000
Cr Forward contract 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.
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.
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
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
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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
31/12/20x1
31/3/20x2
Dr Interest portion 54
Cr Forward contract 54
Dr Inventory 108,300
Cr Payable 108,300
Dr Firm commitment 1,084
Cr Inventory 1,084
30/6/20x2
Dr Cash 1,000
Cr Forward contract 1,000
(2)
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
30 June 20x3
31 December 20x3
Dr Bank 125,000
Cr Interest receipt 125,000
(Receipt of swap differential)
30 June 20x4
Dr Bank 250,000
Cr Interest receipt 250,000
(Receipt of swap differential)
31 December 20x4
Dr Bank 175,000
Cr Interest receipt 175,000
(Receipt of swap differential)
30 June 20x5
Dr Bank 125,000
Cr Interest receipt 125,000
(Receipt of swap differential)
31 December 20x5
Dr Bank 75,000
Cr Interest receipt 75,000
(Receipt of swap differential)
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.
Futures contract
Exercise price $3.21 $3.17 $3.05 $3.00
FV of futures contract $200,000 $800,000 $1,050,000
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
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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.
1 October 20x1
31 December 20x1
[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
[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
Dr Cash 15,500,000
Cr Sales 15,500,000
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
Problem 10.14
Options contract
Premium $0.12 $0.13 $0.175 $0.20
Exercise price $3.30 $3.30 $3.30 $3.30
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1/10/x1
31/12/x1
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
(2)
Without hedging With hedging
Problem 10.15
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
*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.
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Journal entries:
31 July 20x5
Dr Investment (AFS) 250,000
Cr Cash 250,000
(Investment in AFS)
30 September 20x5
Dr Loss on fair value (AFS) 30,000
Cr Investment (AFS) 30,000
Change in fair value of AFS
Dr Cash 28,000
Cr Put option 28,000
(Close option position)
Journal entries:
31 March 20x5
Dr Interest expense 900,000
Cr Cash/bank 900,000
Interest expense for the quarter ended 31 March
30 June 20x5
Dr Interest expense 1,000,000
Cr Cash/bank 1,000,000
Interest expense for the quarter ended 31 March
Dr Cash/bank 100,000
Cr Interest expense 100,000
Net settlement at end of June quarter
30 September 20x5
Dr Interest expense 1,100,000
Cr Cash/bank 1,100,000
Dr Cash/bank 200,000
Cr Interest expense 200,000
Journal entries
31 March 20x5
30 June 20x5
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30 September 20x5
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
Balance sheet
Equity
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
30 June 2011
Dr FX loss on equipment payable 89,740
Cr Equipment payable (0.8333-0.7692)*S$1.4m 89,740
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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
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
30 Jun 2011
Dr Swap interest income (1200*1.2) (or 1200*1.25) 1,440
Cr Cash 1,440
31 Dec 2011
Dr Swap interest income 1,950
Cr Cash (3,000*1.30) 1,950
Swap interest receipt
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Advanced Financial
Accounting
An IFRS® Standards Approach, 3e
Solutions Manual
Chapter 11
Accounting for Taxes on Income
Solutions Manual
Chapter 12
Earnings per Share
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.
(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.
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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
$2,584,000
*$5,000,000 x 3.6%
**$3,000,000 x 1.2%
Note (a)
Note (b):
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Diluted earnings per share = adjusted net profit attributable to ordinary shareholders*
adjusted weighted average number of shares
(2) Basic earnings per share (20x4) = Net profit attributable to ordinary shareholders
Weighted average number of shares
= $2,500,000 - $240,000*
6,166,667**
= 36.65 cents
*$5,000,000 x 0.048
Diluted earnings per share (20x4) = Net profit attributable to ordinary shareholders
Adjusted weighted average number of shares
= $2,500,000
7,416,667
= 33.71 cents
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Note: In the 20x5 financial statements, the comparative 20x4 earnings per share will be adjusted for
the bonus issue as follows:
Problem 12.2
Diluted earnings per share = Adjusted net profit attributable to ordinary shareholders*
Adjusted weighted average number of shares
$5,399,123
Note (a):
IAS 32 requires the convertible bond to be separated into debt and equity components as follows:
PV of principal $7,472,582
$8,315,054
Note: The convertible bond is dilutive as the incremental earnings per share is
$399,123/5,000,000 = 7.98 cents (lower than basic earnings per share).
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Calculation of weighted average number of shares for diluted earnings per share:
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.)
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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.
= $1.90/$1.60
Ex-Rights price:
= 46.44 cents
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= 23.22 cents
Problem 12.4
22,566,667
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The convertible preference shares are dilutive as the incremental earnings is less than the basic earnings
per share.
Problem 12.5
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Note (c):
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Note (e)
Profit = 3.44
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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.
Note (f)
Note (g):
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Problem 12.6
At 1.1.20x3 20,000,000
= -12 cents
= - 1.76 cents
$2,800,000
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:
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= 9.57 cents
Effect Effect
= -$3,000,000/30,875,000
= -9.72 cents
= -0.15 cents
Note: Although the potential ordinary shares are antidilutive (as they reduce the net loss per share)
diluted earnings per share is reported for all three components because the control number is profit
from continuing operation.
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Note (a): Calculation of debt component of convertible bond according to IAS 32:
= $ 380,770 + $9,239,000
= $9,619,770
= $380,230
*see below
Carrying
Cash interest Effective Amortisation Unamortised value
No of shares outstanding/issued
At 1.1.20x4 25,000,000
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[[Note: The contingently issuable shares are included in the weighted number of shares as the necessary
condition has been satisfied.]
Cum-rights price $2
= $68,000,000/40,000,000
= $1.70
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Less excess fair value paid to induce conversion (183,824) Note (d)
Note (d)
*5,000,000 x 500/1000 x 1.25 (bonus issue) x 2/1.7 (bonus element in rights issue) x $2.50
= 8.77 cents
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
Diluted EPS (20x4) = 8.55 cents (convertible preference shares are antidilutive)
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Notes:
(h)
3,125,000
3,676,470*
2,426,470
# 3,750,000 x 4/12
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= -10.2 cents
= - 1.50 cents
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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
The reported preference dividends were $150,000 which did take into account the
dividends in arrears.
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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
Weighted
Profit attributable to ordinary average
shares shares Diluted EPS
Diluted EPS for 20x2 5,200,000 14,550,000 $0.3573
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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
Determine the Earnings per Incremental Share (EPIS) for each type of Potential Ordinary 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
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 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%
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Problem 12.9
(Parts 1, 2 and 3 are reflected on this section)
20x1
= $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.
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Part 4
Sapphire Ltd has fallen in profitability when the 20x2 EPS figures are compared with the restated comparatives. The comparison should be made
against the restated comparatives and not the previously reported EPS figures. The share splits resulted in new shares issued without consideration.
Even though the profit figures have remained stable, the relative performance on a per share basis has deteriorated.
P12.10
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Advanced Financial
Accounting
An IFRS® Standards Approach, 3e
Solutions Manual
Chapter 13
Share-based Payment
CHAPTER 13
CONCEPT QUESTIONS
(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.
(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:
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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.
(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.
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7. Repricing refers to the revision in the exercise price of a share option as a result of a
modification of the terms of a share option plan. If the repricing results in an increase in
the total fair value of the share-based arrangement, the firm should recognise the effect of
the repricing. However, if the repricing results in a decrease in the total fair value of the
share-based arrangement, the modification is ignored as if it had not been made.
8. A share appreciation right is a type of share-based payment plan for employees under which
an employee is entitled to a cash payment equal to the increase in the share price over the
exercise price (the intrinsic value) at settlement date. The liability of the firm is measured
initially based on the fair value of the share appreciation rights and is remeasured at each
reporting period until the date of final settlement.
9. IFRS 2 allows the a firm’s equity instruments to be measured at their intrinsic value in the
rare event that the firm is unable to reliably estimate the fair value of the equity instruments.
The intrinsic value is remeasured at each reporting date until the date of final settlement.
10. In the case of equity-settled share-based transaction, the goods or services received and the
corresponding increase in equity must be measured at the fair value of goods or services
unless the fair value cannot be reliably estimated. The fair value of services rendered by
employees is measured by reference to the fair value of equity instruments at grant date.
This is due to the fact that normally they cannot be measured reliably. In a cash-settled
share-based transaction the entity incurs a liability for goods or services received. The fair
value of the liability has to be remeasured at each reporting date and at the date of
settlement. Any change in the fair value recognized in profit or loss for the period. There is
no such remeasurement for equity-settled transactions.
11. Since P Co has an obligation to settle the share-based payment (SBP) with P Co’s equity
instruments, P has to recognize the SBP as equity-settled. S Co also recognizes the
transaction as an equity-settled because it receives the goods and services and has no
obligation to settle the SBP payment. The Group will recognize the SBP as equity-settled.
Journal entries
P Co (Equity-settled)
Dr Investment in S
Cr Equity
S Co (Equity-settled)
Dr Expense
Cr Equity contributions
Group (Equity-settled)
Dr Expense
Cr Equity
12. In this situation, P Co has an obligation to settle the SBP with employees of its subsidiaries
S Co in S Co’s equity instruments. Since the settlement is in another entity’s instruments,
P Co recognizes the SBP as cash-settled. S Co recognizes the SBP as equity-settled as it is
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the recipient of the goods and services. The group recognizes the SBP as equity-settled as
the equity instruments issued are the group instruments.
Journal entries
P Co (Cash-settled)
Dr Investment in S
Cr Liabilities
S Co (Equity-settled)
Dr Expense
Cr Equity contributions
Group (Equity-settled)
Dr Expense
Cr Equity
13. In this situation, S Co has an obligation to pay its employees remuneration that is pegged
to the price of shares of its parent, P Co. P Co has no obligation to settle the SBP and it is
also not a recipient of goods and services. No entry is required for P Co. For S Co and the
Group, the SBP is accounted for as a cash-settled SBP. S Co is the recipient of services and
it has an obligation to settle the instrument with reference to the share prices. S Co has
an obligation for future cash outflows to its employees. The same obligation applies to the
group.
Journal entries
14. P Co has an obligation to pay to employees of its subsidiary, S Co, remuneration that is
pegged to the price of shares of P Co. In this situation, P Co has an obligation to pay in
cash an amount that is pegged to the share price of its shares. It accounts for the SBP as a
cash-settled SBP and an increase in its investment in S Co. S Co is the beneficiary of the
SBP for services received and accounts for the benefit as an equity contribution from P Co
and the receipt of service as an expense. The group recognizes the expense for the services
received and a liability for the obligation for a future outflow of cash.
Journal entries
P Co (Cash-settled)
Dr Investment
Cr Liabilities
S Co (Equity-settled)
Dr Expense
Cr Equity contributions
Group (Cash-settled)
Dr Expense
Cr Liabilities
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EXERCISES
Exercise 13.1
(Note: This is a discussion question, so no calculation is required. Also, to calculate the remuneration
expense and the liability for each year, additional information pertaining to the fair value of the SARs
would have to be given.)
The share appreciation rights plan is a cash-settled share-based payment arrangement. IFRS 2 requires
a firm to recognise remuneration expense and a liability for services rendered. The fair value of the
liability is measured at 31 December 20x1 based on the estimated fair value of the SARs (this is not the
same as the share price). At 31 December 20x2, remuneration expense and the related liability is
remeasured. As long as the liability has not been fully settled, the liability is remeasured at each
subsequent reporting date. The cash paid out is equal to the intrinsic value of the SARS (share price less
exercise price) at the date of exercise. The liability is gradually reduced when the employees exercised
the SARs and will be fully extinguished when all the eligible employees have exercised the SARs or
the SARs have lapsed.
Exercise 13.2
IGRS 2 requires a firm to recognise the remuneration expense related to services provided by employees
under a share options plan. There are at least two approaches to measuring the remuneration expense to
be recognised in this question. One approach, which is the one favoured by IFRS 2, is to measure the
remuneration expense based on the fair value of the equity instruments issued by the firm. Another
approach is to measure remuneration expense based on the intrinsic value of the equity instruments.
This approach should be used in the rare situation where the fair value of the equity instruments cannot
be reliably measured. In this case, both the estimated fair value and the intrinsic values are provided.
The question is: is the fair value of the equity instruments capable of being fairly measured? The issue
is of great significance to the firm because the measurement approach used will have a great impact on
the firm’s reported earnings during the vesting period. If the fair value of $43 million is considered a
reliable estimate, then the remuneration expense, assuming no forfeiture during the vesting period, will
be $21.5 million for 20x3 and 20x4. However, if the $43 million is considered not a reliably estimated
amount, then measurement of remuneration expense should be based on the intrinsic value which is
$1.9 million in 20x3 and $2.6 million in 20x4.
The use of either the fair value of the equity instrument at grant date or the intrinsic value method also
has accounting consequences in terms of accounting for the tax effects of the remuneration expense. If
the fair value of the equity instrument is used to measure remuneration expense while the related tax
deduction is based on intrinsic value and recognised at the time of exercise, a temporary timing
difference is created. We need to evaluate whether the future tax deductions are greater or less than the
cumulative remuneration expense. If the future tax deductions are greater than the cumulative
remuneration expense, a portion of the tax effect will have to be recognised directly in equity and the
balance recognised in profit or loss. On the other hand, if the cumulative remuneration expense is greater
than the future tax deductions, the entire tax effect is recognised directly in profit or loss. Again there
is a difference in terms of impact on reported earnings.
Normally, the estimated fair value of the options at grant date and the intrinsic values at end of 20x3
and 20x4 should not differ significantly, especially if the estimation period is not long, which is
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usually the case with share options. In this case, the difference between the intrinsic values and the
estimated fair value is simply too great and this suggests that the estimated fair value may not be
reliably estimated. Therefore, measurement of the remuneration expense should be based on the
intrinsic value method.
Exercise 13.3
The share option carries a vesting condition which is a market condition since it has a target share
price. IFRS2 requires the recognition of an expense for services provided regardless of whether the
market condition is satisfied so long as other vesting conditions are satisfied. As the chief executive
was not expected to forfeit the share options, Delphi Company records the following journal enries:
31 May 20x4
31 May 20x5
31 May 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)
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Exercise 13.4
Journal entries:
31 December 20x1
31 May 20x2
PROBLEMS
Problem 13.1
31 December 20x1
31 December 20x2
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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).
(2) Calculation of remuneration expense and allocation to equity and liability are as follows:
IFRS 2:38 requires that the remuneration expense is accounted for separately under the debt and the
equity components as follows:
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Debt component - the remuneration expense is accounted for in accordance with the requirements
applicable to cash-settled share-based payment transactions.
Equity component - the remuneration expense is accounted for in accordance with the requirements
applicable to equity-settled share-based payment transactions.
31 December 20x1
Dr Remuneration expense 119,334
Cr Share option reserves (equity) 2,667
Cr Liability 116,667
(Record share option expense)
31 December 20x2
Dr Remuneration expense 152,667
Cr Share option reserves (equity) 2,667
Cr Liability 150,000
(Record share option expense)
31 December 20x3
Dr Remuneration expense 235,999
Cr Share option reserves (equity) 2,666
Cr Liability 233,333
(Record share option expense)
31 December 20x3
Dr Liability 500,000
Cr Cash 500,000
(Settlement of liability under share-based compensation plan)
31 December 20x3
Dr Liability 500,000
Dr Share option reserves (equity) 8,000
Cr Share capital 508,000
(Settlement of liability under share-based compensation plan by issue of shares)
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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.
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
31 December 20x2
31 December 20x3
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31 December 20x4
(200/300 x 105,000)
31 December 20x5
Problem 13.4
(1) Bonjour to recognize remuneration expense for services received over the three years. The
remuneration is measured base on the fair value of the equity instruments at grant date. This
requirement applies irrespective of any modifications to the terms and conditions on which the
equity instruments were granted, or a cancellation or settlement of that grant of equity
instruments.
(2) The addition of the cash alternative at the end of 20x2 creates an obligation to settle in cash.
Bonjour recognises the liability to settle in cash at the modification date, based on the fair value
of the shares at the modification date and the extent to which the specified services have been
received. (IFRS 2:30 - 33).
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(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.
The addition of a cash alternative at the end of 20x3 creates a liability (obligation to settle in cash) calculated as
follows:
This amount is transferred from equity to liability resulting in a net balance of $20,000 in equity.
*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:
Allocated between:
Equity $ 30,000
Liability $250,000
$280,000
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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.
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.
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.
31 December 20x1
31 December 20x2
Problem 13.6
31 December 20x1
31 December 20x2
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.
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
In 20x3, earnings increase by 33% and the exercise price decreases to $2.01. The estimated fair value
per option increases to $2.00
31 December 20x1
31 December 20x2
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31 December 20x3
1 January 20x4
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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.)
31 December 20x1
Cr Liability 253,333
31 December 20x2
Cr Liability 190,000
31 December 20x3
Cr Liability 366,667
31 December 20x4
Dr Liability 474,000
Cr Cash 390,000
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31 December 20x5
Dr Liability 336,000
Cr Cash 344,000
20x1 253,333
20x2 190,000
20x3 366,667
20x4 (84,000)
20x5 8,000
Total 734,000
Check:
734,000
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