QUESTION 3 Illustration 3: Perpetual debt instruments A Limited issue a bond at principal amount of $ 1000 per bond. The terms of bond require annual payments in perpetuity at a stated interest rate of 8 per cent applied to the principal amount of $ 1000. Assuming 8 per cent to be the market rate of interest for the instrument when it was issued, the issuer assumes a contractual obligation to make a stream of future interest payments having a fair value (present value) of $1,000 on initial recognition. Evaluate the financial instrument in the hands of both the holder and the issuer.
Solution:
The financial instrument in this case is a perpetual debt instrument.
Evaluation of the financial instrument in the hands of the holder:
Classification:
The perpetual debt instrument would be classified as a financial asset at amortized cost under IFRS 9.
Measurement:
The initial measurement of the perpetual debt instrument would be at fair value, which is equal to the present value of the stream of future interest payments at the market rate of 8% per annum. The present value of the stream of future interest payments can be calculated using the formula for the present value of an annuity:
Present value = Annual payment / Market rate of interest
= $80 / 0.08
= $1,000
Subsequent measurement would be at amortized cost using the effective interest method.
Disclosure:
The holder would need to disclose information about the classification and measurement of the perpetual debt instrument in its financial statements.
Evaluation of the financial instrument in the hands of the issuer:
Classification:
The perpetual debt instrument would be classified as a financial liability at amortized cost under IFRS 9.
Measurement:
The issuer would initially recognize the perpetual debt instrument at the present value of the stream of future interest payments, which is $1,000. The issuer would then record an interest expense each year equal to the stated interest rate of 8% multiplied by the principal amount of $1,000. This would result in an annual interest expense of $80.
Subsequent measurement would be at amortized cost using the effective interest method.
Disclosure:
The issuer would need to disclose information about the classification and measurement of the perpetual debt instrument in its financial statements, as well as any significant terms and conditions of the instrument.
Overall, the perpetual debt instrument would be evaluated as a financial asset at amortized cost in the hands of the holder and as a financial liability at amortized cost in the hands of the issuer. The initial measurement would be at fair value, which is equal to the present value of the stream of future interest payments, and subsequent measurement would be at amortized cost using the effective interest method. Appropriate disclosures would need to be provided in the financial statements of both the holder and the issuer.
Overall, the perpetual debt instrument would be classified as a financial liability for both the holder and the issuer and measured at amortized cost using the effective interest rate method. The holder would recognize interest income in profit or loss over the life of the bond, while the issuer would recognize interest expense in profit or loss. Changes in the fair value of the bond would be recognized in other comprehensive income for both the holder and the issuer. The financial statements would need to provide appropriate disclosures about the fair value and effective interest rate used for the bond.