Chapter 9
Q. 9.4
The X Corporation issues 1000 bonds with a nominal value of 1000 $/bond, with a 5% interest rate, payable in 2 instalments. The redemption date is in 2 years. The X Corporation also trades bonds on a short-term basis. By the end of the issue year, the market interest rate is 8%. How should the X Corporation disclose this financial instrument in its annual report?
Step-by-Step
Verified Solution
This financial liability should be measured at fair value through profit and loss, because it is traded on a short-term basis. Therefore, the liability should be re evaluated for the reporting date, at its fair value. Let’s assume that the fair value of the bond cannot be reasonably observed from an active market and the fair value is based upon the discounted cash-flows of the instrument, at the effective interest rate (market rate):
| Cash-flows ($) (1) |
Discount rate (2) |
Present value (3) = (1) * (2) |
|
| Year 1 (interest) | 1 mil * 0.05 = 0.05 mil | 1/(1.08) | 0.046 mil |
| Year 2 (interest + principal) | 1 mil $ + 0.05 mil = 1.05 mil | 1/(1.08)² | 0.900 mil |
| Total | 0.946 mil |
By the end of the first year, the financial liability should be remeasured at its fair value, 0.946 million $, meaning that a 0.054 million $ revenue/gain (1 mil $ − 0.946 mil $) should be disclosed in the P&L Account
0.054 mil $ Financial liability (bond) = Profit and loss 0.054 mil $
A special case concerns the initial recognition and valuation of complex (compound) financial instruments, such as a convertible bond, from the perspective of the issuer. Suppose that a company issues bonds that are convertible at any time into its shares at a stated price, with a fixed interest rate and a specified maturity date. IAS 32 requires the issuer of the financial instrument, which contains both a liability and an equity item, to split the proceeds obtained into a loan and a written call option on the issuer’s shares. This can be done either by measuring the liability component and assigning the residual amount to the equity component or by measuring the two components separately. The IAS 32 favour the first method.