Question

Jill Co. is listed on the stock exchange and needs the advice of an expert regarding their financial instruments. The co. management has therefore approached you to help them account for the following:

 An interest free loan to an employee was given on January 1, 2011 by Jill Co., and it was decided that it will be paid back on December 31, 2012. The market rate on an equivalent loan was 5%.

 Jill Co. is in the expansion phase, and anticipates capital expenditure in the near future. To help fund this expenditure when the need arises, it invests its excess cash into short and long term financial assets. The strategy is to hold these assets to collect the contractual cash flows from them, and to sell them when an opportunity arises to invest in other financial assets that have a higher return. Jill Co. has appointed managers in its treasury department to look after this portfolio, and they are paid on the overall return generated by this portfolio.

Following this strategy, on January 1, 2011, the company purchased $50,000 par value loan notes at a 10% discount on their issue. These loans notes carry a coupon of 3% of par value and carry a redemption date of December 31, 2014. On purchase of these loans, the co. incurred transaction costs of $450. It was determined that the internal rate of return/ effective rate on these notes is 5.6%. By December 31, 2011, interest rates declined, and hence the fair value of these loan notes increased to $51,000.

Required:

Show, with suitable calculations, how the above financial instruments should be accounted for in the financial statements of Jill Co. for the year ended December 31, 2011.

Answer 1

The accounting of financial instruments alongwith their suitable calculations are as follows

1) The value of Notes will be debited by $50,000 and will shown in Assets.

The par value of notes purchased by company - $50,000

2) Discount on Notes will be credited by $2,500 and will shown as deduction from Assets.

Discount on Notes – 5% * Par value of Notes

                              – 5% * $50,000

                               – $2,500

3) Bank will be debited by $47,500.

Net Value of notes paid by the company = Par Value of Notes – Discount thereon

                                                                        = $50,000 - $2,500

                                                                        = $47,500

4) Interest on Notes of $1,500 will be shown in Income Statement as Other Income.

Interest received on Notes – 3% of par value of Notes

                                          – 3% of $50,000

                                          –$1,500

5) Transaction cost of $450 will be shown in Income Statement as Other Expenses.