On 1 January x0, Entity X borrows 100 from Entity Z. The nominal amount of the loan is 110. Interest payment is 4. Interest is payable annually. Remaining lifetime of the loan is 5 years (31 December x0 to x4).

The contractual agreement with Entity Z includes an option that Entity B can prepay the borrowing at any time during the 5 years at an amount of 111 plus accrued interest of the year.

1. Analyse the prepayment option

a. When will Entity X prepay the borrowing? (i.e., make an economic judg-ment when the Entity X dependent on changes in market interest rates will determine that exercising the option will economically beneficial)

b. Based on the classification criteria, analyse whether the prepayment op-tion is an embedded derivative that is separately accounted for from the host contract.

2. Assume that your judgment under 2.b. results in that the prepayment option is separately accounted for as an embedded derivative. Assume that the value for the prepayment option at initial recognition is 3, which is recognised as an asset and adds to the value of the liability.

a. Prepare a schedule for the effective interest calculation of the financial li-ability that the borrowing gives rise to, considering the borrowing of 100 plus the value of the prepayment option 3 for the carrying amount of the financial liability upon initiation. (Use Excel)

b. Make the accounting entry for the entire financial liability (considering the embedded derivative) and the embedded derivative as an asset at initial recognition.

c. At the end of year x0, the interest rates have fallen and the value of the prepayment option has increased from 3 to 5. Make the accounting en-tries for the liability (interest expense accrual and interest payment) as well as the revaluation of the prepayment option.

3. At the end of year x1, the interest rates have fallen further. The value of the prepayment option is now 6. The Entity now decides that it will repay the bor-rowing by using the prepayment option. It thus pays 111 to repay the financial liability.

a. First, make the accounting entries for the liability (interest expense ac-crual and interest payment) as well as the revaluation of the prepayment option.

b. Now, make the accounting entries for the exercise of the early repayment option (based on the updated amortised cost value of the financial liabil-ity, cash payment of 111, and a current value of the prepayment option of 6).