Zx issues a fixed-rate loan for 500,000 and incurs issue costs of 20,000, resulting in an initial carrying value of 480,000. The loan carries an…

It is first necessary to determine whether the call option is closely related to the host debt instrument. Because the fixed premium is required to be paid whenever the call option is exercised after year 4, it is not known if it will be equal to the present value of any interest lost during the remaining term after exercise of the option. Additionally, the call option's exercise price is 5,30,000 (inclusive of the premium) therefore, it is unlikely to be approximately equal to the debt instrument's amortised cost in year 4, or at any subsequent year. Consequently, the call option shall be separated from the host debt contract and accounted for separately. This assumes that the expected life of the instrument is the full 10-year term. Even if the expected life is assumed to be four years, the 10-year loan with a call option after four years is economically same as a four-year loan with a six-year extension option. Because there is no concurrent adjustment to the interest rate after four years, the term extension option would not be closely related, and it would need to be accounted for separately. Thus, whichever way the loan and option are viewed, the embedded derivative needs to be separated. Even though the option is out of the money at inception, because the option's exercise price is greater than the debt instrument's carrying value, it has a time value. Since the value of a callable bond is equal to the value of a straight bond less the value of the option feature, the accounting entries at inception is: Dr. (₹) Cr. (₹) Embedded option (derivative asset) Dr. 10,000 Cash Dr. 4,80,000 To Debt instrument (host) 4,90,000 Since the call option will be fair valued and accounted for separately, with fair value movements taken to profit or loss, it has no impact on the entity's estimate of future cash flows; accordingly, the amortisation period will be the debt host's period to original maturity. The amortisation schedule is shown below: Opening amortised cost ₹ Interest expense @ 8.30213% ₹ Cash payments ₹ Closing amortised cost ₹ Year 1 490,000 40,680 40,000 490,680 Year 2 490,680 40,737 40,000 491,417 Year 3 491,417 40,798 40,000 492,216 Year 4 492,216 40,864 40,000 493,080 Year 5 493,080 40,936 40,000 494,016 Year 6 494,016 41,014 40,000 495,030 Year 7 495,030 41,098 40,000 496,128 Year 8 496,128 41,189 40,000 497,317 Year 9 497,317 41,288 40,000 498,605 Year 10 498,605 41,395 540,000 - The entity would recognize interest expense in profit or loss and the loan's amortised cost in the balance sheet each year, in accordance with the above amortisation schedule.