Change in the fair value of a bond

Change in the fair value of a bond – The following example illustrates the calculation that an entity might perform in accordance with the application guidance in IFRS 9 B5.7.18.

The case:

On 1 January 20X1 an entity issues a 10-year bond with a par value of CU150,0001 and an annual fixed coupon rate of 8 per cent, which is consistent with market rates for bonds with similar characteristics.

The entity uses LIBOR as its observable (benchmark) interest rate. At the date of inception of the bond, LIBOR is 5 per cent. At the end of the first year:

  1. LIBOR has decreased to 4.75 per cent.
  2. the fair value for the bond is CU153,811, consistent with an interest rate of 7.6 per cent.

The entity assumes a flat yield curve, all changes in interest rates result from a parallel shift in the yield curve, and the changes in LIBOR are the only relevant changes in market conditions.Change in the fair value of a bond

Based on Appendix B Application Guidance of IFRS 9 Financial Instruments: a sort of work flow can be made by which the entity can estimate the amount of change in the fair value of the bond that is not attributable to changes in market conditions that give rise to market risk as follows:

Application guidance – Required steps The entity’s estimate

IFRS 9 B5.7.18(a) First, the entity computes the liability’s internal rate of return at the start of the period using the observed market price of the liability and the liability’s contractual cash flows at the start of the period. It deducts from this rate of return the observed (benchmark) interest rate at the start of the period, to arrive at an instrument-specific component of the internal rate of return.

At the start of the period of a 10-year bond with a coupon of 8 per cent, the bond’s internal rate of return is 8 per cent.

Because the observed (benchmark) interest rate (LIBOR) is 5 per cent, the instrument-specific component of the internal rate of return is estimated at 3 per cent.

IFRS 9 B5.7.18(b)  Next, the entity calculates the present value of the cash flows associated with the liability using the liability’s contractual cash flows at the end of the period and a discount rate equal to the sum of

  1. the observed (benchmark) interest rate at the end of the period and

  2. the instrument-specific component of the internal rate of return as determined in accordance with paragraph B5.7.18(a).

Change in the fair value of a bond

The contractual cash flows of the instrument at the end of the period are:

  • interest: CU12,000 (= CU 150,000 x 8%) per year for each of years 2–10.
  • principal: CU150,000 in year 10.

The discount rate to be used to calculate the present value of the bond is thus 7.75 per cent, which is the end of period LIBOR rate of 4.75 per cent, plus the 3 per cent instrument-specific component.

This gives a present value of CU152,367

PV = [CU12,000 × (1 – (1 + 0.0775)^-9)/0.0775] + CU150,000 × (1 + 0.0775)^-9.

IFRS 9 B5.7.18(c) The difference between the observed market price of the liability at the end of the period and the amount determined in accordance with paragraph B5.7.18(b) is the change in fair value that is not attributable to changes in the observed (benchmark) interest rate. This is the amount to be presented in other comprehensive income in accordance with paragraph 5.7.7(a).

Change in the fair value of a bond

Change in the fair value of a bond

The market price of the liability at the end of the period is CU153,811

Market price = [CU12,000 × (1 –

(1 + 0.076)^-9)/0.076] + CU150,000 × (1 + 0.076)^-9.

Thus, the entity presents CU1,444 in other comprehensive income, which is CU153,811 – CU152,367, as the increase in fair value of the bond that is not attributable to changes in market conditions that give rise to market risk.

Change in the fair value of a bond

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