Financial instruments IFRS 9 IFRS 13 DIPIFR Acca past papers

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ACCA Past question papers on IFRS 9 Financial Instruments

All questions on Financial Instruments standards (IFRS 9, IFRS 7, IFRS 13 and IAS 32)  which have appeared in ACCA DipIFR from June 2014 have been indexed here. The answers are based on the standards prevalent at the exam point in time.

For the benefit of the readers, we have put the following sequentially to help them understand better

  • Question - Relevant portion of the exam pertaining to the standard has been recreated
  • Answer - Answers as shared by the ACCA Examination team which was required for the question
  • Examiners Feedback - Feedback on answers given by the students for that exam, this is a critical part of learning as students can learn from mistakes which other students did

Question 

Delta is an entity which prepares financial statements to 31 March each year. The financial statements for the year ended 31 March 2015 are to be authorised for issue on 30 June 2015. The following events are relevant to these financial statements:


On 1 April 2014, Delta purchased 1 million options to acquire shares in Epsilon, a listed entity. Delta paid 25c per option, which allows Delta to purchase shares in Epsilon for a price of $2 per share. The exercise date for the options was 31 December 2014. On 31 December 2014, when the market value of a share in Epsilon was $2·60, Delta exercised all its options to acquire shares in Epsilon. In addition to the purchase price, Delta incurred directly attributable acquisition costs of $100,000 on the purchase of the 1 million shares in Epsilon.
Delta regarded the shares it purchased in Epsilon as part of its trading portfolio. However, Delta did not dispose of any of the shares in Epsilon between 31 December 2014 and 31 March 2015. On 31 March 2015, the market value of a share in Epsilon was $2·90.

Explain and show how this event should be reported in the financial statements of Delta for the year ended 31 March 2015.

Answer

Under the provisions of IFRS 9 – Financial Instruments – the option to acquire shares in Epsilon would be regarded as a derivative financial instrument. This is because the value of the option depends on the value of an underlying variable (Epsilon’s share price), it requires a relatively small initial investment and it is settled at a future date. 


A derivative financial instrument is initially measured at its fair value. In this case fair value will be the price paid – which is $250,000 at 1 April 2014. Derivative financial instruments are remeasured to fair value at the reporting date and gains or losses on remeasurement recognised in the statement of profit or loss. However, in this case the derivative is derecognised on 31 December 2014, when the option is exercised. On 31 December 2014, the investment in Epsilon’s shares would be regarded as a financial asset. 


Under IFRS 9, financial assets are initially measured at fair value, so the initial carrying value of the shares in the books of Delta will be $2·6 million (1 million X $2·60).  The difference between the carrying value of the new asset – $2·6 million and the price paid plus the derecognised derivative – $2·25 million ($2 million + $250,000) will be taken to profit or loss for the year ended 31 March 2015 as investment income. In this case $350,000 will be included as investment income. Because the investment in Epsilon is an equity investment, it will continue to be remeasured to fair value at each year end. Because the investment is part of a trading portfolio, the investment is measured at fair value through profit or loss. 


Therefore the acquisition costs of $100,000 must be recognised as an expense in the statement of profit or loss for the year ended 31 March 2015.  The investment is included in the statement of financial position at 31 March 2015 as a current asset at its fair value of $2·9 million.  The increase in fair value of $300,000 ($2·9 million – $2·6 million) is taken to the statement of profit or loss.

Examiners Feedback:

A number of candidates did not identify that the share option was a derivative which needed to be measured at fair value through profit or loss. The majority of candidates realised that the shares that were purchased by the exercising of the option needed to be measured at fair value. However many candidates stated that the measurement basis should have been fair value through other comprehensive income, despite the question making it clear that these shares were part of a trading portfolio. This should have led candidates to conclude that the shares should be measured at fair value through profit or loss. As a result many candidates incorrectly stated that the transaction costs should be included in the initial carrying value of the equity investment, rather than being immediately taken to profit or loss.

      Question 

      You are the financial controller of Omega, a listed entity which prepares consolidated financial statements in accordance with International Financial Reporting Standards (IFRS). The managing director, who is not an accountant, has recently attended a business seminar at which financial reporting issues were discussed. Following the seminar, she reviewed the financial statements of Omega for the year ended 31 March 2016. Based on this review she has prepared a series of queries relating to those statements:

      ‘One of the issues discussed at the seminar was ‘impairment of financial assets’. On reviewing our financial statements I have noticed that we have two types of financial assets – Type A (those measured at amortised cost) and Type B (those measured at ‘fair value through profit or loss’). It appears we carry out impairment reviews of Type A assets but not Type B assets. Please explain to me why this is the case and also please explain exactly how an impairment review of Type A assets is carried out.’

      Answer

      A financial asset is impaired when its carrying amount cannot be reasonably expected to be recovered through future generation of income or sale proceeds. 
      (Note: Exact words NOT needed here, just the sense of the point.)
      IFRS 9 – Financial Instruments – classifies financial assets into three types. One of these types is ‘fair value through profit and loss’. Where financial assets are measured on this basis, any impairment of the asset is automatically reflected in the measurement basis so no further action is required. 

      As far as other financial assets are concerned, the general rule is that we should recognise a loss allowance for ‘expected credit losses’. The loss allowance should be recognised in profit or loss and deducted from the carrying amount of the financial asset in the statement of financial position.  A credit loss is the difference between the cash flows we are contractually entitled to receive in respect of
      a financial asset and the cash flows which are expected based on current circumstances.  Unless the credit risk attaching to the financial asset has increased significantly since initial recognition, the loss allowance should be based on expected credit losses in the next 12 months. 


      Where the credit risk has increased significantly since initial recognition, the loss allowance should bebased on lifetime expected credit losses.  As far as trade receivables and (by choice) lease receivables are concerned, as a simplifying measure IFRS 9 allows the loss allowance to always be measured based on the lifetime expected credit losses.

      Examiners Feedback:

      This topic is tested for the first time since it had been included into DipIFR programme (December 2015). That is why there were reasonable expectations for this topic to appear in the exam paper. Unfortunately, not all candidates were aware of this model. Many candidates simply described three stages of impairment though in the standard there is no such structuring. In doing this they
       were demonstrating neither deep understanding, nor knowledge of accurate terminology. In general this was focused on two assumptions:
      – in case where credit risk is not significant, the loss allowance is recognized basing on expected credit loss during the next 12 months;
      – in case where credit risk increased significantly the loss allowance is based on the credit losses which are expected through lifetime.

      Some candidates scored an easy mark mentioning that where financial assets are measured at fair value through profit and loss, any impairment of the asset is automatically reflected in the measurement basis, so no further action is required.
      Only few candidates gave the definition of credit loss mentioning discounted cash flows which are expected under current circumstances. 

      Some candidates described impairment with reference to IFRS (IAS) 39 (old) comparing amortised cost and future cash flows expected from the instrument using initial effective rate and recognizing the impairment loss, which is not in keeping with IFRS 9. It should be noted once again that answers that do not address the requirements of the question will not be awarded marks. In this particular case there was no need to waste time for definitions of financial instruments, classification of financial assets including criteria, business models for managing FAs, etc. It was no need to describe requirements of IFRS (IAS) 36 – Impairment of Assets - and to compare carrying value with recoverable amount to arrive at the impairment loss. Those candidates who recognized that they were not aware of the impairment of FAs and that IFRS (IAS) 36 is not relevant at least save valuable time missing this question.

      Question 

      (a)One of the matters addressed in IFRS 9 – Financial Instruments is the initial and subsequent measurement of financial assets. IFRS 9 requires that financial assets are initially measured at their fair value at the date of initial recognition. However, subsequent measurement of financial assets depends on their classification for which IFRS 9 identifies three possible alternatives.
      Required:
      Explain the three classifications which IFRS 9 identifies for financial assets and the basis of measurement which is appropriate for each classification. You should also identify any exceptions to the normal classifications which may apply in specific circumstances.

      (b) Kappa prepares financial statements to 30 September each year. During the year ended 30 September 2016 Kappa entered into the following transactions:
      (i) On 1 October 2015, Kappa made an interest free loan to an employee of $800,000. The loan is due for repayment on 30 September 2017 and Kappa is confident that the employee will repay the loan. Kappa would normally require an annual rate of return of 10% on business loans 


      (ii) On 1 October 2015, Kappa made a three-year loan of $10 million to entity X. The rate of interest payable on the loan was 8% per annum, payable in arrears. On 30 September 2018, Kappa will receive a fixed number of shares in entity X in full settlement of the loan. Entity X paid the interest due of $800,000 on 30 September 2016 and entity X has no liquidity problems. Following payment of this interest, the fair value of this loan asset at 30 September 2016 was estimated to be $10·5 million. 


      (iii) On 1 October 2015, Kappa purchased an equity investment in entity Y for $12 million. The investment did not give Kappa control or significant influence over entity Y but the investment is seen as a long-term one. On 30 September 2016, the fair value of Kappa’s investment in entity Y was estimated to be $13 million.

      Answer: 

      (a) The classification and measurement of financial assets is largely based on:
      The business model for managing the asset – specifically whether or not the objective is to hold the financial asset in order to collect the contractual cash flows. 
      Whether or not the contractual cash flows are solely payments of principal and interest on the principal amount outstanding. 
      Where the business model for managing the asset is to hold the financial asset in order to collect the contractual cash flows and the contractual cash flows are solely payments of principal and interest on the principal amount outstanding, then the financial asset is normally measured at amortised cost. 
      Where the business model for managing the asset is to both hold the financial asset in order to collect the contractual cash flows and to sell the financial asset and the contractual cash flows are solely payments of principal and interest on the principal amount outstanding, then the financial asset is normally measured at fair value through other comprehensive income. Interest income on such assets is recognised in the same way as if the asset were measured at amortised cost. 
      In other circumstances, financial assets are normally measured at fair value through profit or loss. 
      Notwithstanding the above, where equity investments are not held for trading, an entity may make an irrevocable election to measure such investments at fair value through other comprehensive income. 
      Finally an entity may, at initial recognition, irrevocably designate a financial asset as measured at fair value through profit or loss if to do so eliminates or significantly reduces an accounting mismatch.


      (b) (i) The loan is a financial asset which would initially be recognised at its fair value on 1 October 2015. 
      Given the fact that Kappa normally requires a return of 10% per annum on business loans of this type, the loan asset should be initially recognised at $661,157 ($800,000/(1·10)2).  An amount of $138,843 ($800,000 – $661,157) would be charged to profit or loss at 1 October 2015. 
      Because of the business model and the contractual cash flows, this loan asset will subsequently be measured at amortised cost. 
      Therefore $66,116 ($661,157 x 10%) will be recognised as finance income in the year ended 30 September 2016. The closing loan asset $727,273 will be ($661,157 + $66,116). This will be shown as a current asset since repayment is due on 30 September 2017. 


      (ii) Since the loan is at normal commercial rates, the loan would initially be recognised at $10 million – the amount advanced. 
      The interest received and receivable of $800,000 would be credited to profit or loss as finance income. 
      In this case, the contractual cash flows are not solely payments of principal and interest on the principal amount outstanding. Therefore the asset would be measured at fair value through profit or loss. 
      A fair value gain of $500,000 ($10·5 million – $10 million would be recognised in profit or loss. 
      The loan asset of $10·5 million would be shown as a non-current asset. 1⁄2

      (iii) The equity investment would be initially recognised at its cost of purchase – $12 million.
      The contractual cash flows relating to an equity investment are not solely payments of principal and interest on the principal amount outstanding. Therefore the asset would normally be measured at fair value through profit or loss. This would result in a gain on remeasurement to fair value of $1 million ($13 million – $12 million) being recognised in profit or loss. 
      Since the equity investment is being held for the long term, rather than as part of a trading portfolio, it is possible to make an irrevocable election on 1 October 2015 to classify the asset as fair value through other comprehensive income. In such circumstances, the remeasurement gain of $1 million would be recognised in other comprehensive income rather than profit or loss.

      Examiners Feedback:

      Answers to part (a) were mixed. Most candidates were able to identify that there were three different measurement bases for financial assets dependent on the nature of the cash flows and the business model. However only a minority of candidates were able to correctly describe when each measurement basis would be appropriate. A minority of candidates mistakenly thought they were being asked to describe the requirements of IFRS 13 – Fair Value. This was not asked for and did not attract marks. Other candidates wasted time by referring to the measurement of financial liabilities and equity instruments – the question was clearly focused on financial assets. Still other candidates made out of date references to the classifications used in IAS 39 – the predecessor standard. A popular reference in this regard was to ‘Available for Sale’ assets.

      Most candidates realised that the loan to the employee (part b(i)) was a financial asset that should be measured at amortised cost. However only about half the candidates realised that the initial carrying amount of the asset (on which the subsequent amortised cost measurement was based) would be the fair value of the loan at its inception (involving discounting).


      Answers to part b(ii) were generally rather disappointing. Few candidates appreciated that the three year loan to company X failed the ‘contractual cash flow test’, meaning that the loan asset would be classified as fair value through profit or loss. A minority of candidates attempted to compute a ‘split presentation’ of the financial instrument along the lines of a convertible loan treated as part liability and part equity. All in all, answers to this part were unsatisfactory.

      Answers to part b(iii) were generally satisfactory. Almost all candidates appreciated that equity investments had to be measured at fair value. However only some candidates mentioned the need to make an election should Kappa wish to measure the asset at fair value through other comprehensive income.

      Question 1

      On 1 January 2017, Alpha agreed to purchase goods from a foreign supplier. This purchase is due to be made and paid for on 30 June 2017. The directors of Alpha decided to hedge the cash-flow risk attaching to this future purchase by entering into a derivative contract and to formally designate the derivative as a hedging instrument. The hedge met all of the effectiveness requirements for the use of hedge accounting. On 31 March 2017, the derivative had a positive fair value resulting in a gain to Alpha of $5 million. Between 1 January 2017 and 31 March 2017 the expected cash flows in respect of the purchase of goods on 30 June 2017 had increased by $4·2 million. Alpha has not made any accounting entries in respect of this arrangement.

      Answer:

      Ineffective portion of cash flow hedge (5,000 – 4,200) 800

      Question 2

      On 31 March 2017, Delta was owed $10m by entity Z. The amount was due for payment by 30 April 2017. Entity Z has been a customer for many years and has an excellent payment record. At 31 March 2017, there was no reason to suppose that entity Z would fail to pay the $10m owed to Delta by 30 April 2017. By 20 April 2017, entity Z’s going concern status was in considerable doubt.

      Explain and state (where possible by quantifying amounts) how this event would be reported in the financial statements of Delta for the year ended 31 March 2017.

      Answer

      Doubts regarding the going concern status of a customer would normally be regarded as prima facie evidence that any trade receivable had suffered impairment. In such circumstances an impairment allowance equal to the expected losses would normally be appropriate. However, IFRS 9 Financial Instruments requires the impairment assessment to be made at the reporting date.  At the reporting date, the going concern status of Z was not in doubt, so in this case no allowance is necessary. 


      However, the information about the decline in the going concern status of Z after the reporting date is a non-adjusting event after the reporting date.  Therefore whilst no impairment allowance is necessary, it will be necessary to disclose details of the 20 April event at Z’s business premises and its impact on the collectability of Delta’s trade receivable.

      Examiners Feedback

      Many candidates did not realise that, according to the provisions of IFRS 9 – Financial Instruments – the review of a financial asset for impairment should be based upon conditions existing at the reporting date. The event giving rise to the doubts regarding the going concern status of entity Z (event (c)) occurred
      after the year-end and so was non-adjusting.

      Question 3

      You are the financial controller of Omega, a listed entity which prepares consolidated financial statements in accordance with International Financial Reporting Standards (IFRS). One of your assistants, a trainee accountant, is involved in the preparation of the consolidated financial statements for the year ended 31 March 2017. She is also involved in the preparation of the individual financial statements for the entities in the group. She has sent you an email with the following queries:

      I notice that on 1 April 2016 we lent $50 million to a key supplier. The loan has an annual rate of interest of 5%, with interest of $2·5 million payable on 31 March each year in arrears. The loan is repayable on 31 March 2026 but I believe that if interest rates change, we might consider assigning the loan to a third party. As it turns out, interest rates have fallen since 1 April 2016 and the fair value of the loan asset at 31 March 2017 was $52 million. I have been told that this loan asset should be measured at ‘fair value through other comprehensive income’. Why is this? I thought loan assets were measured at amortised cost. If the loan asset is measured at fair value through other comprehensive income, does the interest income get recorded in other comprehensive income rather than profit or
      loss?

      Answer:

      The measurement basis for financial assets is set out in IFRS 9 Financial Instruments. The measurement basis depends on the business model for managing the financial asset and the contractual cash flow characteristics of the financial asset. 


      In order for the financial asset to be measured at amortised cost, the contractual terms should give rise to cash flows on specified dates which are solely payments of principal and interest on the amounts outstanding. This condition is satisfied in the case of the loan you are querying. There is, however, another condition to be satisfied. The asset should be held under a business model whose objective is to hold the financial asset in order to collect the contractual cash flows. This condition is not satisfied, given the possibility of assigning the loan should interest rates rise. A financial asset is measured at fair value through other comprehensive income where the ‘contractual cash flow test’ is passed and the asset is held under a business model whose objective is achieved both by collecting the contractual cash flows and by selling the financial asset. This appears to be the case here, so classification as fair value through other comprehensive income seems appropriate. 


      Where a financial asset is measured at fair value through other comprehensive income, the interest income which is included in profit or loss is the same amount as would be recorded were the asset to be measured at amortised cost. Therefore interest income of $2·5 million will be recorded in profit or loss.  The increase in fair value of $2 million ($52 million – $50 million) will be recorded in other
      comprehensive income.

      Examiners feedback

      Many candidates seemed unaware that the basis for the classification and subsequent accounting treatment of a financial asset under IFRS 9 – Financial
      Instruments - was the contractual cash flows and the business model. A common error was to insist that loan assets are always measured at amortised cost. Another reasonably common error was to state that, where a financial asset is measured at fair value through other comprehensive income, the interest income is also recognised in other comprehensive income. However a minority of candidates produced very good answers to this part, indicating that careful study of the relevant standard pays dividends.

       

      Question - You are the financial controller of Omega, a listed entity which prepares consolidated financial statements in accordance with International Financial Reporting Standards (IFRS). You have recently prepared the financial statements for the year ended 30 September 2017 and these are due to be published shortly. The managing director has reviewed these financial statements and has prepared a list of queries arising out of the review.
      Query 
      I’m confused about our treatment of equity investments in listed entities that we don’t control. There seem to be two different treatments in our financial statements. One of the notes to the financial statements says that the equity investments we hold to temporarily invest surplus cash balances are measured at fair value and that changes in fair value are recognised in profit or loss. Another note says that the equity investment we hold in a key supplier is measured at fair value and that changes in fair value are recognised in other comprehensive income (OCI). Earnings per share (EPS) is a key performance indicator for Omega, so please explain how it can be justified to use two different treatments for equity investments made by the same entity. Please also explain what the impact on EPS might be if a gain or loss is reported in OCI rather than profit or loss.

      Answer:

      The accounting treatment of equity investments which we do not control or significantly influence is dealt with in IFRS 9 – Financial Instruments. 
      Under IFRS 9, equity investments are financial assets which fail the ‘contractual cash flow test’. Equity investments must be measured at fair value. 
      Under IFRS 9, gains or losses on the remeasurement of financial assets measured at fair value are normally taken to profit or loss.  In the case of equity investments not held for trading, it is possible to make an irrevocable election at initial recognition to recognise gains or losses on the remeasurement to fair value in other comprehensive income. 
      The IASB Conceptual Framework for Financial Reporting makes no clear conceptual distinction between gains and losses reported in profit or loss and gains and losses reported in other comprehensive income. The distinction between profit or loss and other comprehensive income does have some practical relevance, however.  The distinction is particularly important for listed entities. Such entities are required to report their earnings per share under IAS 33 – Earnings per Share. Gains and losses reported in profit or loss affect earnings
      per share whereas gains or losses reported in other comprehensive income do not.

      Examiners Feedback:

      Answers to the first part of the question were generally satisfactory. The majority of candidates were able to explain the contrasting accounting treatment in terms of the differing reasons for making the two equity investments. However the discussion of the implications of gains or losses being reported in profit or loss or other comprehensive income was generally below the standard that might be expected. A minority of candidates did state that amounts included in profit or loss affect earnings per share whilst amounts included in other comprehensive income do not. However very few candidates mentioned that as a listed entity the disclosure of earnings per share was mandatory for Omega.

       

      There were two questions in June 2018

      Question : One of the issues covered by IFRS 9 Financial Instruments (revised July 2014) is the classification and measurement of financial assets. The three possible measurement bases identified by the standard are:
      – Amortised cost.
      – Fair value through other comprehensive income.
      – Fair value through profit or loss.

      Required:
      Explain how IFRS 9 requires entities to select the appropriate measurement basis for a financial asset. You should include any options available to entities regarding classification in your explanation.
      Note: You are NOT required to define a financial asset.

      Answer: Under IFRS 9, the basis for classifying and measuring financial assets is the business model for managing the financial asset and the contractual cash flow characteristics of the financial asset. 


      Where the business model for managing the financial asset is to hold the financial asset to collect the contractual cash flows and where the contractual terms of the financial asset give rise on specified dates to cash flows which are solely payments of principal and interest on the principal amount outstanding, then the financial asset is measured at amortised cost. 


      Where the business model for managing the financial asset is to both hold the financial asset to collect the contractual cash flows and to sell the financial asset and where the contractual terms of the financial asset give rise on specified dates to cash flows which are solely payments of principal and interest on the principal amount outstanding, then the financial asset is measured at fair value through other comprehensive income. 


      If a financial asset is not measured at amortised cost or fair value through other comprehensive income, then it is measured at fair value through profit or loss (the default category). An entity can make an optional irrevocable election on initial recognition that particular investments in equity instruments which would otherwise be measured at fair value through profit or loss be measured at fair value through other comprehensive income. This election is only possible if the
      equity investment is not ‘held for trading’. 


      Notwithstanding the above, an entity may, at initial recognition, irrevocably designate a financial asset as measured at fair value through profit or loss if to do so would eliminate or reduce a measurement or recognition inconsistency which would otherwise arise from measuring assets or liabilities or recognising gains or losses on them on different bases (an ‘accounting mismatch’).

       

      Question 2: 

      Epsilon prepares financial statements to 31 March each year. The following events have occurred which are relevant to the year ended 31 March 2018:
      (i) On 1 April 2017, Epsilon loaned $30 million to another entity. Interest of $1·5 million is payable annually in arrears. An additional final payment of $35·3 million is due on 31 March 2020. Epsilon incurred direct costs of $250,000 in arranging this loan. The annual rate of interest implicit in this arrangement is approximately
      10%. Epsilon has no intention of assigning this loan to a third party at any time. (4 marks)
      (ii) On 1 April 2017, Epsilon purchased 500,000 shares in a key supplier – entity X. The shares were purchased in order to protect Epsilon’s source of supply and Epsilon has no intention of trading in these shares. The shares cost $2 per share and the direct costs of purchasing the shares were $100,000. On 1 January 2018,
      the supplier paid a dividend of 30 cents per share. On 31 March 2018, the fair value of a share in entity X was $2·25. (5 marks)
      (iii) On 1 January 2018, Epsilon purchased 100,000 call options to purchase shares in entity Y – an unconnected third party. Each option allowed Epsilon to purchase shares in entity Y on 31 December 2018 for $6 per share. Epsilon paid $1·25 per option on 1 January 2018. On 31 March 2018, the fair value of a share in entity Y was $8 and the fair value of a share option purchased by Epsilon was $1·60. This purchase of call options is not part of a hedging arrangement. (4 marks)

      Required:
      Explain and show how the three events should be reported in the financial statements of Epsilon for the year ended 31 March 2018. In part (b) you should assume that Epsilon only measures financial assets at fair value through profit or loss when required to do so by IFRS 9.
      Note: The mark allocation is shown against each of the three events above.

      Answer:

      (i) Since the business model is to collect the contractual cash flows and the cash flows consist solely of the repayment of principal and interest, this asset is measured at amortised cost. 

      The initial carrying amount of the financial asset will be $30·25 million ($30 million fair value + $250,000 transaction costs).

      The finance income recorded under investment income category in the statement of profit or loss for the year ended 31 March 2018 will be $3·025 million ($30·25 million x 10%).

      The carrying amount of the financial asset in the statement of financial position at 31 March 2018 will be $31·775 million ($30·25 million + $3·025 million – $1·5 million). 

      ii) Since this is an equity investment which Epsilon has no intention of selling, Epsilon can measure the investment at fair value through other comprehensive income (provided irrevocable election on initial recognition has been made). 

      Since the financial asset is measured at fair value through other comprehensive income, the transaction cost (agent’s commission) is included in the initial fair value of shares (500,000 x $2 + $100,000).

      The carrying amount of the financial asset in the statement of financial position at 31 March 2018 will be $1·125 million based on fair value of shares at the year end (500,000 x $2·25). 

      The difference (fair value gain) of $25,000 ($1·125 million – $1·1 million) will be recognised in other comprehensive income. 

      Dividend income of $150,000 (500,000 x 30 cents) will be recognised as other income in the statement of profit or loss.

      iii. The call option cannot be measured at amortised cost or fair value through other comprehensive income, so it must be measured at fair value through profit or loss. 


      The initial carrying value of the call option will be $125,000 (100,000 x $1·25). 1
      At the year end, the call option will be re-measured to its fair value of $160,000 (100,000 x $1·60).

      The fair value gain of $35,000 ($160,000 – $125,000) will be recognised in the statement of profit or loss.

      Examiners Feedback:

      Part (a) was answered satisfactorily by a majority of candidates. Most had clearly studied the relevant financial reporting standard and were able to provide the relevant explanations. A minority of candidates did not read the requirements carefully enough and explained the meaning of the three different measurement bases rather than when they should be used. Such explanations, even when correct, attracted no marks because they were not asked for. 

      Answers to part (b) lacking in substance. In part (i) a significant number of candidates attempted to compute the carrying amount of the loan by discounting the total anticipated cash flows using the implicit rate of interest, that was provided in the question. Often these calculations were performed incorrectly This showed a lack of understanding of the meaning of the term ‘implicit rate of interest. Another common error in part(i) was to either deduct the loan arrangement costs from the carrying amount of the loan, or to state that they would be expensed immediately to profit or loss.

      In part (ii) the majority of candidates did not realise that as expressed in the scenario the shares in entity X
      would be measured at fair value through other comprehensive income, rather than fair value through profit or loss.

      Part (iii) was generally answered rather better, although some candidates
      wasted time by discussing hedge accounting, when the question specifically stated that the purchase of the share options was not part of a hedging arrangement.

       

      Question 

      You are the financial controller of Epsilon, a listed entity. The financial statements of Epsilon for the year ended 31 March 20X7 are currently being prepared. Your managing director has sent you three questions regarding the
      financial statements. The questions appear in notes 1–3.

      I’ve been analysing Epsilon’s equity investments and they appear to be being treated inconsistently in the financial statements. I have noted the following:
      – We have a portfolio of equity investments which we use for the short-term investment of surplus cash. When we need cash for business purposes we sell some investments from this portfolio. The portfolio is measured at its fair value each year end. Any surpluses or deficits on re-measurement to fair value are recognised in investment income as part of the profit or loss for the period.
      – We have two long-term equity investments in key suppliers which we have held for some time and have no intention of selling. These investments are also measured at fair value but changes in fair value are recognised as ‘other comprehensive income’. How can it be consistent to report changes in the fair values of our equity investments as different line items in the same financial statement?

      Please explain the measurement requirements of the relevant international financial reporting standard. Additionally, what difference does it make to Epsilon whether gains or losses are reported in other comprehensive income rather than as part of the profit or loss for the period? 

      Answer: 

      Equity investments are financial assets and are subject to the recognition and measurement requirements of IFRS 9 – Financial Instruments. 


      IFRS 9 identifies three classes for financial assets – amortised cost (AC), fair value through other comprehensive income (FVTOCI) or fair value through profit or loss (FVTPL). 


      IFRS 9 states that the class of into which a particular financial asset is allocated depends on the business model for managing the financial assets and the contractual cash flows associated with those assets. AC can only be used where the contractual cash flows consist solely of the receipt of interest and repayment
      of the principal sums outstanding. This does not apply to equity shares, so the AC method cannot be used. 


      The default category for measuring equity investments is at FVTPL. This is the method which has been used for the portfolio which has been held for the short-term investment of surplus cash. 


      However, if an equity investment is not held for trading, it is possible to make an election on initial recognition to measure the investment at FVTOCI. This election has been made in respect of the equity investments in two key suppliers which we have held for the long term and have no intention of selling. 


      The key difference between reporting a gain or loss as part of profit or loss or as part of other comprehensive income is that in the former case the gain or loss affects earnings per share, which is an important performance measure for listed entities like Epsilon. Equity investments are financial assets and are subject to the recognition and measurement requirements of IFRS 9 


      Examiners Feedback:

      not all candidates described the ‘business model’ and ‘contractual cash flow’ tests that inform the relevant measurement basis for financial assets.

      Question:

      Gamma prepares its financial statements to 30 September each year. Notes 1 and 2 contain information relevant to these financial statements:
      Note 1 – Purchase of equity shares in a key supplier On 1 October 20X6, Gamma purchased 200,000 equity shares in entity A, a key supplier. Entity A’s shares are listed on the local stock exchange. This share purchase did not give Gamma control or significant influence over entity A but Gamma intends to retain the shares in entity A as a long-term strategic investment.

      Gamma paid $2·40 per share for these shares. This amount represents their fair value at the date of purchase. Additionally, brokers charge a fee of 2% of the amounts paid to buy or sell a share on the stock exchange on which entity A’s shares are quoted.


      On 31 March 20X7, entity A paid a dividend of 25 cents per share. For the last few years entity A has made just one dividend payment each year, in the month of March. On 30 September 20X7, information received from the local stock exchange regarding entity A’s share price was:
      – Broker’s bid price (the price the broker will pay to buy a share) – $2·70 per share.
      – Broker’s ask price (the price which the broker requires when selling a share) – $2·90 per share. 

      Explain and show how the transactions would be reported in the financial statements of Delta for the year ended 30 September 20X7.

      Answer:

      Under the principles of IFRS® 9 – Financial Instruments – equity investments must be measured at fair value because the contractual terms associated with the investment do not entitle the holder to specific payment of interest and principal (sense of the point only needed). 

      The fair value of the investment in entity A at the date of purchase is $480,000 (200,000 x $2·40).  The amount actually paid for the shares (incorporating broker’s fee) in entity A on 1 October 20X6 was $489,600 (480,000 x 1·02). 
      The difference between the price paid for the shares and their fair value is $9,600 ($489,600 – $480,000). This difference is regarded as a transaction cost by IFRS 13 – Fair Value Measurement. 


      IFRS 9 would normally require equity investments to be measured at fair value through profit or loss. Where financial assets are measured at fair value through profit or loss, transaction costs are recognised in profit or loss as incurred. Therefore in this case, $9,600 would be taken to profit or loss on 1 October
      20X6. 


      Under the principles of IFRS 13, the fair value of an asset is the amount which could be received to sell the asset in an orderly transaction. Where the asset is traded in an active market (as is the case for the investment in entity A), then fair value should be determined with reference to prices quoted in that market. Therefore the fair value of the investment in entity A at the year end is $540,000 (200,000 x $2·70).  The year-end fair value of $540,000 is unaffected by the broker’s fees which would be incurred if the shares were to be sold – these fees are not a component of fair value measurement. 


      The change in fair value of $60,000 ($540,000 – $480,000) between 1 October 20X6 and 30 September 20X7 would be taken to profit or loss at the end of the reporting period. The dividend received of $50,000 (200,000 x 25 cents) would be recognised as other income in profit or loss at 31 March 20X7.
      Because the shares in entity A are not held for trading, Gamma has the option to make an irrevocable election on 1 October 20X6 to measure the shares at fair value through other comprehensive income.

      Were this election to be made, then the transaction cost would be included in the initial carrying amount of the financial asset, making this $489,600. 
      The difference between the closing fair value of the investment and its initial carrying amount is $50,400 ($540,000 – $489,600). This is recognised in other comprehensive income.  The dividend income of $50,000 is still recognised in profit or loss regardless of how the financial asset is measured.

      Examiners Feedback

      Most candidates realised that, in the absence of control or significant influence by Gamma, the relevant financial reporting standard to apply was IFRS 9 – Financial Instruments. However a minority of candidates made inappropriate references to IAS 24 – Related Party Disclosures. In the absence of control or significant influence a key supplier is not a related party according to IAS 24. A number of candidates were not specific enough in applying IFRS 9 to the scenario. They should have stated that, under IFRS 9, equity investments are measured at fair value through profit or loss unless they are held for the long term and an
      irrevocable election is made to measure them at fair value through other comprehensive income. Instead they wasted time talking about IFRS 9 measurement issues regarding the business model and the contractual cash flows concerning financial assets generally. Much of this discussion was
      not relevant to the scenario. Even where candidates did move on to discuss accounting for the investment under both fair value alternatives the following common errors occurred:
      1. Stating that the broker’s fee payable on purchase (a transaction cost) is always charged as an expense. This is not so where the investment is measured at fair value through other comprehensive income – in this case the transaction cost is included in the initial carrying amount of the investment.
      2. Deducting the transaction cost from the carrying amount of the investment rather than adding it.
      3. Time apportioning the dividend received from the investment on 31 March 20X7 (half-way through the current accounting period) and only including six months of this dividend as income.
      4. Stating that, where the investment is measured at fair value through other comprehensive income, dividend income is recognised in other comprehensive income rather than in profit or loss.
      5. Incorrectly computing the fair value of the investment at the reporting date. A number of candidates used the ask price rather than the bid price, or even an average of the two. Others included the brokers fee that would be payable on sale of the share as part of the fair value measurement. In a number of cases candidates demonstrated little understanding of the requirements of IFRS 13 – Fair Value Measurement.

      Question:

      On 1 January 20X4, Gamma entered into a firm commitment to purchase a machine from a supplier whose functional currency is the kroner. This firm commitment was not an onerous contract. The cost of the machine was 14·4 million kroner and the agreed delivery date was 30 June 20X4. Gamma was due to pay 14·4 million kroner to the supplier on 31 July 20X4.

      On 1 January 20X4, Gamma entered into a forward exchange contract with a bank to purchase 14·4 million kroner for $1·44 million on 31 July 20X4. The forward exchange contract was entered into so as to provide a hedge against the currency risk associated with the firm commitment to purchase the machine.

      On 30 June 20X4, Gamma took delivery of the machine and immediately brought the machine into use. Gamma estimated that the machine would have a useful life of five years from 30 June 20X4, with no residual value.

      On 31 July 20X4, Gamma paid 14·4 million kroner to the supplier of the machine and received payment of $360,000 from the bank in settlement of the forward exchange contract (see below).

      Gamma designated the forward exchange contract as a hedge of the cash flows expected to arise on the purchase of the machine. This contract was a perfectly effective hedge of those cash flows. Gamma wishes to use hedge accounting to reflect the above transactions in its financial statements.

      Relevant exchange rates and fair values of the forward exchange contract are as follows:

      Using the information , explain and show how this event would be reported in the consolidated financial statements of Gamma for the year ended 31 March 20X5.

      Note: The mark allocations are indicated in each note above. Marks will be awarded for explanations as well as for computations.

      .

      Answer:

      The firm commitment to purchase the machine is a non-onerous executory contract until the date of delivery. Therefore, under the principles of IAS 37 – Provisions, Contingent Liabilities and Contingent Assets – no obligation would be recognised in the financial statements of Gamma until the machine was delivered.

      Under the principles of IFRS 9 – Financial Instruments – the forward exchange contract is a derivative financial instrument and so would be classified as fair value through profit or loss.

      This would normally mean that gains or losses on re-measurement to fair value would be recognised in profit or loss.

      However, where the derivative contract is designated as a cash flow hedge of a future firm commitment, IFRS 9 allows the effective portion of the change in fair value to be recognised in other comprehensive income. They will be presented as gains which may subsequently be reclassified to profit or loss.

      Because the hedge is 100% effective, then in this case the whole of the change in the fair value of the derivative will be recognised in other comprehensive income.

      This means that a gain of $60,000 would be recognised in other comprehensive income of Gamma for the year ended 31 March 20X4 and a further gain of $100,000 ($160,000 – $60,000) recognised in other comprehensive income of Gamma for the year ended 31 March 20X5 (up to 30 June 20X4).

      Under the principles of IAS 21 – The Effects of Change in Foreign Exchange Rates – on 30 June 20X4 when the asset is delivered, the transaction will be translated using the spot rate at that date.

      This means that $1·6 million (14·4 million/9) will be debited to property, plant and equipment and credited to trade payables.

      Under the principles of IFRS 9, given that hedge accounting is used, the cumulative gains on re-measurement of the derivative which have been recognised to 30 June 20X4 as other comprehensive income will be included in the carrying amount of the property, plant and equipment.

      The cumulative gains will have been accumulated in a cash flow hedge reserve and the inclusion of these gains in property, plant and equipment will be achieved by a direct transfer out of this reserve. This transfer will not affect other comprehensive income.

      This means that $160,000 ($60,000 + $100,000) will be debited to the cash flow hedge reserve and credited to property, plant and equipment.

      The carrying amount of the property, plant and equipment following this transfer will be $1·44 million ($1·6 million – $160,000).

      The property, plant and equipment is a non-monetary asset so its carrying amount will not be affected by future exchange rate fluctuations.

      The property, plant and equipment will be depreciated over its useful life of five years from 30 June 20X4. Therefore depreciation of $216,000 ($1·44 million x 1/5 x 9/12) will be charged to profit or loss as an operating expense for the year ended 31 March 20X5.

      The closing balance of property, plant and equipment on 31 March 20X5 will be $1,224,000 ($1·44 million – $216,000).

      For the period from 30 June 20X4 to 31 July 20X4, the further change in fair value of the derivative of $200,000 ($360,000 – $160,000) will be recognised as a gain in other comprehensive income.

      The derivative is a financial asset and this asset will be de-recognised on 31 July 20X4 when $360,000 is received from the bank.

      The liability to pay for the property, plant and equipment will be discharged on 31 July 20X4 by a payment of $1·8 million ($14·4 million/8).

      The loss on exchange of $200,000 ($1·8 million – $1·6 million) will be recognised in profit or loss as an operating expense.

      At the same time, the gain on re-measurement of the derivative between 30 June 20X4 and 31 July 20X4 of $200,000 which had previously been recognised in other comprehensive income will be reclassified to profit or loss as a reclassification adjustment.

      This means that the overall amount recognised in other comprehensive income for the year ended 31 March 20X5 will be a gain of $100,000 ($100,000 gain + $200,000 gain – $200,000 re-classification).

      Examiners Feedback

      Answers to part (b) were generally unsatisfactory. A large number of candidates stated incorrectly that the machine would be recognised on 1 January 20X4, the date on which the firm commitment was entered into, rather than 1 June 20X4, the date the machine was delivered and brought into use.

      Hardly any candidates provided an explanation of why the firm commitment was not recognised on 1 January 20X4. Similarly, hardly any candidates made the initial explanation of the treatment of the hedging derivative that would normally be required under IFRS 9 Financial Instruments - were hedge accounting not used. Many candidates wasted time by providing unnecessary explanations of the conditions set out in IFRS 9 that needed to be in place for cash-flow hedge accounting to be used. The question made it very clear that these conditions were in place and so what was necessary was to explain and show how the use of hedge accounting would affect the specific scenario.

      A reasonable number of candidates were able to state that the gains arising on the hedging derivative between 1 January 20X4 and 30 June 20X4 were initially recognised in other comprehensive income rather than profit or loss. However very few went on to state that on recognition of the machine on 30 June 20X4 these gains would be deducted from the initial carrying value of the machine. Only a minority of candidates specifically identified that the gains arising on re-measurement of the derivative in July 20X4 (from the date of recognition of the liability to the date of its settlement) would be initially recognised in other comprehensive income but then re- classified to profit or loss when the liability was settled.

      To end the observations regarding part (b) of this question on a positive note, most candidates were able to appropriately compute depreciation of the machine and the exchange loss on settlement of the liability to pay for the machine (the ‘own figure rule was used here for marking purposes).

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