Exercise 1 A company issues $$ 0 \% $$ loan notes at their nominal value of $$ \$ 40,000 $$ at the beginning of the year. The loan notes are repayable at a premium of $$ \$ 11800 $$ after 3 years. The effective rate of interest is $$ 9 \% $$. Required: (a) What amount will be recorded as a financial liability when the loan notes are issued? (b) What amounts will be shown in the statement of profit or loss and the statement of financial position for years $$ 1-3 $$ ?

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(a) The note is repaid at a total of 
$$
\$40\,000+\$11\,800=\$51\,800,
$$
after 3 years. Under the effective interest method the financial liability is initially measured at the present value of the future cash flows using the effective interest rate, $$ 9\% $$. That is,

$$
\text{Initial carrying amount} = \frac{\$51\,800}{(1.09)^3}.
$$

Calculating the denominator:

$$
(1.09)^3 \approx 1.29503.
$$

Thus,

$$
\text{Initial carrying amount} \approx \frac{\$51\,800}{1.29503} \approx \$40\,000.
$$

---

(b) For each year, the effective interest method requires that we recognize interest expense equal to the opening carrying amount multiplied by $$ 9\% $$ and then “accrete” the carrying amount. No cash is paid until maturity.

1. **At issuance (Time 0):**

$$
   \text{Carrying amount} = \$40\,000.
   $$

2. **Year 1:**

- **Interest expense:** 
     
     $$
     \$40\,000\times 0.09=\$3\,600.
     $$
     
   - **Carrying amount at end of Year 1:** 
     
     $$
     \$40\,000+\$3\,600=\$43\,600.
     $$
     
   In the statement of profit or loss for Year 1, the interest expense of $$\$3\,600$$ is recognized. In the statement of financial position at the end of Year 1, the liability is shown at $$\$43\,600$$.

3. **Year 2:**

- **Interest expense:** 
     
     $$
     \$43\,600\times 0.09=\$3\,924.
     $$
     
   - **Carrying amount at end of Year 2:** 
     
     $$
     \$43\,600+\$3\,924=\$47\,524.
     $$
     
   So, for Year 2, $$\$3\,924$$ is the interest expense in profit or loss and the liability is shown at $$\$47\,524$$ in the statement of financial position.

4. **Year 3:**

- **Interest expense:** 
     
     $$
     \$47\,524\times 0.09\approx\$4\,277.
     $$
     
   - **Carrying amount at end of Year 3 (before repayment):** 
     
     $$
     \$47\,524+\$4\,277\approx\$51\,801.
     $$
     
     (Any minor rounding differences aside, this amount will equal the repayment amount.)
     
   At maturity, the note is repaid at $$\$51\,800$$ and the liability is removed from the balance sheet. In the statement of profit or loss for Year 3, interest expense of approximately $$\$4\,277$$ is recognized.

Thus, summarizing:

- **Year 1:** 
  - Interest expense: $$\$3\,600$$
  - Liability at year-end: $$\$43\,600$$

- **Year 2:** 
  - Interest expense: $$\$3\,924$$
  - Liability at year-end: $$\$47\,524$$

- **Year 3:** 
  - Interest expense: $$\$4\,277$$ (approximately)
  - Liability at maturity (after adding interest): $$\$51\,800$$ which is then repaid.

These are the amounts to be shown in the statement of profit or loss (interest expense) and in the statement of financial position (carrying amount of the liability) over the 3 years.
(a) When the loan notes are issued, the financial liability recorded is \$40,000. (b) For each of the three years, the company will recognize an interest expense of \$3,600, \$3,924, and \$4,277 respectively. The liability will increase to \$43,600, \$47,524, and \$51,801 at the end of each year, and will be fully repaid at \$51,800 at the end of the third year.

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