Question

Question 5 (20 marks)

1. ABC Ltd. issued an option to Mr. Wong for $2,000 on April 1, 2018. The option entitles Mr. Wong to buy 1,000 of XYZ Ltd’s ordinary shares at $10 per share at any time in the next 12 months. The market price of XYZ’s ordinary shares on April 1, 2018 was $12 per share; however, the current market price today is only $9 per share.                     [5 marks]

Required:

Determine the classification of ABC’s financial instruments above. Justify your answer

2.   On April 1, 2018, ABC Ltd. issued a financial instrument to Mr. Lee for $1,000,000. The rate of return is linked to the movement in gold price over the next twelve months. If, at any time in the next twelve months, the gold price is higher than HK$10,000 per ounce, Mr. Lee will receive 3% return on investment. Otherwise, the return on investment will be 0%. Mr. Lee’s investment and return on investment will be delivered to him on March 31, 2019. [5 marks]

Required:

Determine the classification of ABC’s financial instruments above. Justify your answer

3.   HSCC started the business and issued 10,000 ordinary shares (par value $2) at $20 per shares   in 2015. The fiscal year is from January 1 to December 31 each year.

On July 1, 2018, HSCC reacquires 1,000 shares of its ordinary shares at $30 per share (par value @$2).

On October 1, 2018, HSCC issued a two-year callable financial instrument for $100,000. The rates of return for the first year and the second year are 1% and 2% respectively, payable annually at the end of each year. The rate of return for an instrument with similar credit risk but without a redemption option is 1.2%. HSCC has the right to redeem the certificate of deposit at face value at any time before maturity. If the redemption does not occur, the holder will receive the amount of initial investment back at maturity.

On November 1, 2018, the company announced and paid dividend of $1 per share.

Required: Prepare the relevant journal entries for the fiscal year 2008. In your entry, specify whether the instrument issued on Oct 1 is an equity, a liability, or a compound instrument.  

[10 marks]

Answer 1

Introduction:International Accounting Standards IAS 32 and 39 define a financial instrument as "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial Instruments are classified as:

A.Primary Financial Instruments/Cash Instruments: instruments whose value is determined directly by the markets. For example, Receivables,Payables etc
B.Derivative Financial Instruments: These are the instruments which derive their value from the value and characteristics of one or more underlining entities such as an asset, index, or interest rate. They can be exchange-traded derivatives and over-the-counter (OTC) derivatives.
Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps.

Answer: 1

The Employee Stock option is Derivative Financial Instruments.
Employee stock options have to be expensed under US GAAP in the US. Each company must begin expensing stock options no later than the first reporting period of a fiscal year.

Hence in given case, ABC Ltd issued share options to Mr.Wong which is derivative Financial instrument. And ABC ltd have to start expensing the amount from year 2018.

Answer 2.

The return on investment for Mr.Lee and liability to pay to ABC Company is depending upon the future price of gold in market. As per explanation given, the transaction between Mr.Lee and ABC ltd is derivative Financial Instrument.