C1- CORPORATE REPORTING REVIEW QUESTIONS- COVENANT FINANCIAL CONSULTANTS

Example 1
On 1January 2001 Denis issued a $50m three-year convertible bond at par. There were no issue costs. The
coupon rate is 10%, payable annually in arrears on 31st December. The bond is redeemable at par on 1January
2004. Bondholders may opt for conversion. The terms of conversion are two-cent equity shares for every $1
owed to each bondholder on 1January 2004. Bonds issued by similar entities without any conversion rights
currently bear interest at 15%. Assume that all bondholders opt for conversion in full.
Required: How will this be accounted for by Denis?

Example 2
Ming has two receivables that it has factored to a bank in return for immediate cash proceeds of less than the
face value of the invoices. Both receivables are due from long standing customers who are expected to pay in
full and on time. Ming has agreed a three-month credit period with both customers.

The first receivable is for $200,000 and in return for assigning the receivable Ming has just received from the
factor $180,000. Under the terms of the factoring arrangement this only money that Ming will receive
regardless of when or even if the customer settles the debt, i.e. the factoring arrangement is said to be
“without recourse”

Second receivable is for $100,000 and in return for assigning the receivable Ming has just received from the
factor $70,000. Under the terms of the factoring arrangement if the customer settles the account on time then
a further $5,000 will be paid by the factoring bank to Ming, but if the customer does not settle the account in
accordance with the agreed terms then the receivable will be reassigned back to Ming who will then be
obliged to refund the factor the original $70,000 plus a further $10,000. This factoring arrangement is said to
be “with recourse”.
Required:
Discuss Ming’s accounting treatment of the monies received under the terms of the two factoring
arrangements.

Solution
In the first arrangement the $180,000 has been received as a one-off, non refundable sum. This is factoring
without recourse for bad debts. The risk of bad debt has clearly passed from Ming to the factoring bank.
Accordingly Ming should derecognize the receivable and there will be an expense of $20,000 recognised. No
liability will be recognized.

In the second arrangement the $70,000 is simply a payment on account. More may be received by Ming
implying that Ming retains an element of reward. The monies received are refundable in the event of default
and as such represent an obligation. This means that the risk of slow payment and bad debt remains with
Ming who is liable to repay the monies so far received. As such despite the passage of legal title the asset (i.e
receivable) should remain recognized in the accounts of Ming. In substance Ming has borrowed $70,000 and
this loan should be recognized immediately. This will increase the gearing of Ming.

Example 3
Jones bought an investment for $40million plus associated transaction costs of $ 1million. The asset was
designated upon initial recognition as fair value through other comprehensive income. At the reporting date

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the fair value of the financial asset had risen to $60million. Shortly after the reporting date the financial asset
was sold for $70million.

Required:
(i) How should this be accounted for
(ii) How would the answer have been different if the investment has been classified as at
fair value through profit and loss?

Solution
(i) On purchase the investment is recorded at the consideration paid including, as the
asset is classified as fair value through other comprehensive income, the associate
transaction costs:
$m
Dr Asset 41
Cr Cash 41

At the reporting date the asset is re-measured and the gain is recognized in other comprehensive income and
taken to equity:

Dr Asset 19
Cr Other components of equity 19

On disposal, the asset is derecognized, the gain or loss on disposal is determined by comparing disposal
proceeds and carrying value, with the result taken to profit or loss.
Dr Cash 70
Cr Asset 60
Cr Profit 10

Note that any gains or losses previously taken to equity are not recycled upon de-recognition, although they
may be reclassified within equity.
(ii) If Jones had designed the investment as fair value through profit or loss, the
transaction costs would have been recognized as an expense in profit or loss. So on
purchase:

Dr Asset 40
Cr Cash 40

Dr Expense 1
Cr Cash 1

Subsequent measurement – at fair value through profit or loss:

Dr Asset 20
Cr Profit 20

On disposal the asset is derecognized with the gain taken to income

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Dr Cash 70
Cr Asset 60
Cr Profit 10

Example 4
Matrix Entertainment Software Solutions has entered into the following transactions involving the sale of
several of its financial assets during the last year.

(a) Sale of a financial asset for Tshs20 million. There are no conditions attached to the
sale and no other rights and obligations are retained by Matrix.
(b) Sale of an investment in shares for Tshs20 million. However, Matrix retains a call
option to repurchase the shares at any time at the current fair value on the date of the
repurchase of the shares.
(c) Sale of a part of its short-term receivables for Tshs200 million. According to the
terms of the sale, it promises to pay Tshs6 million to compensate the buyer, Cannon
Cable Entertainment, for any defaults on payment. The expected credit losses on this
transaction are significantly lower than Tshs6 million and there are no significant
risks
(d) Sale of receivables worth Tshs20 million. According to the terms of the sale, Matrix
retains the right to service the receivables for a fixed fee of Tshs7 million.
(e) Matrix enters into a total return swap with Evanessence Media Works, the essence of
which will return any increases in the fair value of the shares worth Tshs20 million
sold to Matrix and compensate Evanessence for any decreases in the fair value of the
shares.

Required:
You are required to state to what extent derecognition of these assets is appropriate in the financial statements
in each of the above cases.

Example 5
Consider the following cases:

(a) Black Co owes Sparrow Co Tshs25 million. Black Co has set this amount aside in a
special trust that it will not use for any other purpose but to pay Sparrow Co.
(b) Sparrow Co pays Black Co Tshs25 million in discharge of an earlier obligation.
(c) A put option written by Jack Co expires.

Required:
In which cases would you, as an accountant, derecognise the above financial liabilities?

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EXAMPLE 6: Impairment

Parent A has two wholly owned subsidiaries B and C. Subsidiary C owns four of the five major and well
known consumer brands of the group. Parent A is in a strong financial position and is expected to inject cash
into Subsidiary C to cover Subsidiary C’s cash outflows over the next years.

– On 1 January 2018, Subsidiary B provides a loan of TZS 100,000,000 to Subsidiary C for three years;

– The loan is guaranteed by Parent A;

– On 31 December 2019, Subsidiary C is expected to have cash flow problems due to deterioration in
economic conditions and decreasing profits arising from reductions in consumer spending.

Question: Do the facts on 31 December 2019 give rise to a significant increase in credit risk and therefore
require the recognition of lifetime ECL?

Answer:

IFRS 9.B5.5.17(k) notes that one factor that should be assessed in determining whether there has been a
significant increase in credit risk is the change in the quality of the guarantee provided by a parent, if the
parent has an incentive and the financial ability to prevent a default by capital or cash infusion. It appears
that Parent A is in a strong financial position and has an incentive to prevent Subsidiary C from default by
providing it with additional funds. It is therefore considered that there has been no significant increase in
credit risk and the loan should remain in Stage 1. However, Subsidiary B needs to monitor Parent A’s
financial position and also whether there has been any change in circumstances that would lessen or reduce
the incentive for Parent A to prevent default by Subsidiary C.

EXAMPLE 7: Impairment

On 1 January 2011, Company A provided a TZS 100M loan to Company C for four years at an annual interest
rate of 10%; On 31 December 2012, Company C is expected to have cash flow problems in future due to a
deterioration in economic conditions; On 31 December 2013, the loan is extended for another three years
because Company C is in financial difficulty does not have enough cash to repay the loan.

Question: How should the loan be accounted for under the three-stage expected loss model?

Answer:

31 December 2011

Loan is in Stage 1;

– Estimate the probability that company C will default over the next 12 months;

– Assume there is a 1% probability of company C defaulting in the next 12 months and, if there is a default,
Company A will not get any amount back (100% loss);

– Recognise provision of TZS 1M (1% x TZS100M);

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– Recognise interest on the gross carrying amount of the loan (TZS 100 x 10%).

31 December 2012

– Loan is in Stage 2 It is considered that credit risk has increased significantly as Company C is expected to
have cash flow in future problems due to a deterioration in economic conditions;

– The probability that company C will default over the remaining life of the loan is estimated at 35% and, if
there is a default, there will be a 100% loss;

– Recognise a provision of TZS 35M (35% x TZS 100M);

– Recognise interest on the gross carrying amount of the loan (TZS 100 x 10%).

31 December 2013

– Loan is in Stage 3 Due to liquidity problems, Company C is in financial difficulty and is not able to repay the
loan and relies on an extension of the loan for three years. The loan is therefore credit impaired;

– Company A estimates that the probability of default over the remaining life of the loan is 60% and, if there
is a default, there will be a 100% loss;

– Recognise a provision of TZS 60M (60% x TZS 100M);

– Recognise interest on the net carrying amount of the loan (TZS 40 x 10%) from the beginning of the next
reporting period.

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 C1- CORPORATE REPORTING REVIEW QUESTIONS- COVENANT FINANCIAL CONSULTANTS

REVIEW QUESTIONS

QUESTION 01
Bazoo Inc is an upcoming manufacturer of health products that uses traditional medicine and methods as its
USP (unique selling point). As part of its local and overseas expansion, it makes several investments.
i. An unconditional receivable from one of its clients, LAPSO.
ii. A forward contract entered into on 12 March 20X6, to purchase 9% bonds at Tshs10,000 on 12 June
20X6.
iii. On 5 January 20X6, Bazoo lays down plans for the purchase of the above mentioned 9% bonds.
iv. On 2 February 20X6, Basil enters into a firm commitment to purchase a boiler machine that is
designated as a hedged item in a fair value hedge of the associated foreign currency risk.
A hedged item is an asset, liability or a future transaction that exposes the entity to the risk of changes in
future cash flows.
Required:
CEO of Bazoo has asked you to state with reasons whether these transactions entered into during the past
year would be recognised as financial assets or financial liabilities under IAS 39.
QUESTION 02
ADIE Plc, a CD manufacturing company has entered into the following transactions involving financial
instruments:
i. ADIE gave a loan to BADU an emerging recording company during the year. Although BDU owes
ADIE money, this transaction does not give rise to a trade receivable. It is a part of portfolio that the
company manages in order to collect the contractual cash flowsDuring the year, ADIE made an
investment in 500 equity shares at Tshs12,000 per share of Silk Plc quoted in an active market.
However, this investment was not made or held for trading purposes.
ii. ADIE made an investment in 200 equity shares at TShs10,000 per share of Cowell Industries which
are not held for trading; do not have a quoted price and whose fair value cannot be reliably measured.
iii. ADIE’s investment in debt securities which is not quoted in an active market and is not held for
trading.
iv. During the year, ADIE purchased debt securities of NITE Corp. These debt instruments were quoted
in an active market and ADIE plan on holding on to them until maturity. However, if market interest
rates fall significantly, ADIE will consider selling the debt securities in order to realise the associated
gain.
v. ADIE make a strategic investment in an equity instrument which they, at the moment, have no
intention to sell.
vi. During the year, ADIE made another investment in SUSH Plc which was held for trading purposes.
Required:
ADIE Plc needs you as an accountant, to help them classify these transactions into the appropriate category
of financial asset or liability. However, you also need to keep in mind that several transactions can fall into
more than one category.
QUESTION 03
During the year, Glad Co issued the following financial instruments:
i. 10,000 9% preference shares redeemable after ten years
ii. Fred bonds paying 5% interest each year which do not have maturity dates assigned to them
iii. A call option that allows the holder to purchase a fixed number of ordinary shares from Glad Co for a
predetermined amount of cash
iv. 5,000 5% preference shares redeemable at the option of the shareholder
Required:
State with reasons whether or not the above items can be classified as financial liabilities.
QUESTION 04
Mazimbe Plc incurred the following financial assets and liabilities during the year 20X7.
i. Purchase of a debt security for Tshs25 million with transaction costs of Tshs0.2 million. The debt

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security is held for trading purposes.

ii. Equity shares purchased for Tshs4 million. The dealer fee paid was Tshs0.75 million. Mazimbe
elected to classify these shares as financial assets at fair value through profit or loss.

iii. During the year, Mazimbe purchased a bond of Tshs10 million at a premium of Tshs0.1 million and
classified it as at amortised cost sale. Transaction costs incurred on the bond were Tshs0.15 million.
iv. Mazimbe issued a bond for Tshs600 million and incurred issuance costs of Tshs1.2 million. This
bond was measured at amortised cost by Mazimbe.
Required:
As their accountant, determine the initial carrying amount of each of the above financial instruments.
QUESTION 05
Pilau Plc, a kitchen appliance manufacturing company acquired the following financial instruments during
the year 20X5:
i. Shares (held for trading) of Maze Inc, a publishing company quoted on the London Stock Exchange.
ii. Unquoted shares of Abii, a scientific research company, the fair value of which can be estimated
using valuation techniques.
iii. Shares of Peter, a children’s clothing manufacturing company that is not quoted on the stock market
and whose fair value cannot be measured reliably.

iv. Derivative instruments that are linked to and must be settled by unquoted equity instruments the fair
value of which cannot be measured reliably.
v. Bonds of Razii Corp quoted on the active market.

vi. Unquoted bonds of Fredy Machinery.

Required:
How would the above financial instruments be measured at the end of the financial year?

QUESTION 06
As at 31 December 20X4, Tuma Co holds shares amounting to Tshs15 million in Savvy Inc which have been
classified as at fair value through profit or loss. The fair value of these shares as at 31 December 20X5 is
Tshs14.3 million. They were sold for Tshs15.55 million on 25 July 20X6. The dividend received on these
shares was Tshs150,000 in 20X5 and Tshs500,000 in 20X6.

Required:

How will these

transactions be recorded in the books of Tuma Co?

QUESTION 07
The directors of Aron, a public limited company, are worried about the challenging market conditions which
the company is facing. The markets are volatile and illiquid. The central government is injecting liquidity into
the economy. The directors are concerned about the significant shift towards the use of fair values in financial
statements. IFRS 9 Financial instruments in conjunction with IFRS 13 Fair value measurement defines fair
value and requires the initial measurement of financial instruments to be at fair value. The directors are
uncertain of the relevance of fair value measurements in these current market conditions.
Required
a. Briefly discuss how the fair value of financial instruments is measured, commenting on the
relevance of fair value measurements for financial instruments where markets are volatile
and illiquid. (4 marks)

b. Further they would like advice on accounting for the following transactions within the
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financial statements for the year ended 31 May 20X8.

(i) Aron issued one million convertible bonds on 1 June 20X5. The bonds had a term of three
years and were issued with a total fair value of $100 million which is also the par value.
Interest is paid annually in arrears at a rate of 6% per annum and bonds, without the
conversion option, attracted an interest rate of 9% per annum on 1 June 20X5. The company
incurred issue costs of $1 million. If the investor did not convert to shares they would have
been redeemed at par. At maturity all of the bonds were converted into 25 million ordinary
shares of $1 of Aron. No bonds could be converted before that date. The directors are
uncertain how the bonds should have been accounted for up to the date of the conversion on
31 May 20X8 and have been told that the impact of the issue costs is to increase the effective
interest rate to 9.38%. (6 marks)
(ii) Aron held a 3% holding of the shares in Smart, a public limited company, The investment
was classified as an investment in equity instruments and at 31 May 20X8 had a carrying
value of $5 million (brought forward from the previous period). As permitted by IFRS 9
Financial instruments, Aron had made an irrevocable election to recognise all changes in fair
value in other comprehensive income (items that will not be reclassified to profit or loss).
The cumulative gain to 31 May 20X7 recognised in other comprehensive income relating to
the investment was $400,000. On 31 May 20X8, the whole of the share capital of Smart was
acquired by Given, a public limited company, and as a result, Aron received shares in Given
with a fair value of $5.5 million in exchange for its holding in Smart. The company wishes to
know how the exchange of shares in Smart for the shares in Given should be accounted for in
its financial records. (4 marks)

Note. The following discount and annuity factors may be of use.

Discount Annuity
factors factors
6% 9% 9.38% 6% 9% 9.38%
1 year 0.9434 0.9174 0.9142 0.9434 0.9174 0.9174
2 years 0.8900 0.8417 0.8358 1.8334 1.7591 1.7500
3 years 0.8396 0.7722 0.7642 2.6730 2.5313 2.5142

QUESTION 8
The publication of IFRS 9, Financial instruments, represents the completion of the first stage of a three-part
project to replace IAS 39 Financial instruments: recognition and measurement with a new standard. The new
standard purports to enhance the ability of investors and other users of financial information to understand the
accounting of financial assets and reduces complexity.
Required
a. Discuss the approach taken by IFRS 9 in measuring and classifying financial assets and the main
effect that IFRS 9 will have on accounting for financial assets. (11 marks)
b. Grainger, a public limited company, has decided to adopt IFRS 9 prior to January 20X2 and has
decided to restate comparative information under IAS 8 Accounting policies, changes in accounting
estimates and errors. The entity has an investment in a financial asset which was carried at amortised
cost under IAS 39 but will be valued at fair value through profit and loss (FVTPL) under IFRS 9. The
carrying value of the assets was $105,000 on 30 April 20X0 and $110,400 on 30 April 20X1. The
fair value of the asset was $106,500 on 30 April 20X0 and $111,000 on 30 April 20X1. Grainger has
determined that the asset will be valued at FVTPL at 30 April 20X1.
Required
Discuss how the financial asset will be accounted for in the financial statements of Grainger in the year ended
30 April 20X1. (4 marks)

QUESTION 09
(a) Evaluate whether each of the listed items (i) to (v) is a financial instrument and whether it should be
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accounted for under IAS 32. Financial Instrument Presentation

(i) Cash deposited in banks

(ii) Prepaid expenses
(iii) Gold bullion deposited in banks
(iv) Finance lease receivables or payables
(v) Trade accounts receivable

(b) Extract from the trial balance on GOME as at 30th June 2015 are as follows.
Dr Cr
TZS millions TZS millions
Financial assets at amortized cost 53,240
Financial assets of FVTOCI 35,400
Financial assets at FVTPL 73,200
Investment income 5,000
Proceeds from disposal of financial assets 8,000
Retained earnings 125,500
FVTOCI Reserve 30,800

Note 1
The financial assets measured at amortized cost represent an investment in loan notes of another entity.
GOME invested TZS 50,000 million, their nominal value, in 10% loan notes will be repaid at premium on
30th July 2013. Transaction costs of TZS 2,000 million were incurred. The loan notes will be repair at
premium on 30th July 2017. Their effective interest rate is 12%. The interest due as receivable in the year and
credited to investment income

Note 2
The FVTOCI investments are recorded in the trial balance at their fair value as at 30 th June 2014. During the
year, an investment which had original cost of TZS 3,000 million was sold for cash proceeds of TZS 8,000
million. Only the cash proceeds have been recorded in the above trial balance. Its fair value as at 30th June
2014 was TZS 6,500 million. The fair value of the remaining investments at 30 th June 2015 was measured at
TZS 6,700 million.

Note 3
The FVTPL financial assets are recorded in the trial balance at their fair value as at 30th June 2014 plus the
cost of financial assets purchased in the year. Financial assets were purchased during the year at a cost of
TZS 12,500 million plus transaction costs of TZS 1,500 million which have also been capitalized.

The fair value of all these investments at 30th June was TZS 84,700 million

REQUIRED:
Prepare the extracts of the following GOME’s financial statements for the year ended 30th June 2015.

(i) Statement of Profit or Loss and other comprehensive income

(ii) Statement of financial position

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