Question

ABC Ltd is an Australian company issued $10 million convertible notes on 1 July 2019 that carry a nominal interest (coupon) rate of 5% per annum. They are redeemable on 30 June 2022 for cash or can be exchanged for ordinary shares in ABC Ltd on the basis of 20 shares for each $100 of note. The prevailing market interest rate for the notes without conversion options are 8%.

When preparing the draft financial statements for the year ended 30 June 2020, the directors are proposing to show the convertible note within equity in the statement of financial position, as they believe all the convertible note holders will choose the equity option when the convertible note is due for redemption. They further intend to charge a finance cost of $500,000 ($10 million x 5%) in the income statement for each year up to the date of redemption.

Required:

Prepare extracts to show how the convertible notes and the finance charge should be treated by ABC Ltd in its financial statements for the year ended 30 June 2020. Show your workings.               

Using Australian Accounting System - AASB

Answer 1

Technical literature-

A financial liability is any liability that is: (a) a contractual obligation : (i) to deliver cash or another financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or (b) a contract that will or may be settled in the entity’s own equity instruments.

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

An instrument shall be classified as equity

(a) when there is discretion on part of the Company to either pay or convert in orinary shares

(b) When an instrument is compulsorily convertible to ordinary shares

All other instrument shall be classified as financial liability at fair value and can be subsequently classified as financial liability at amortised cost, FVTPL or FVTOCI.

Analysis-

In the given case convertible notes is either repayable or convertible and an option has been given to the bondholders. The Company expects that the bondholders shall convert the convertible note in equity shares.

As per the technical literature, an instrument shall be clssified only when it is either convertible instrument or it is discretionary on part of the Company to convert or repay.

The terms of note provides an option to Noteholders to either convert or repay and Convertible Notes does not meet the conditions of equity classification as per the AASB. Hence, convertible note shall be classified as the Financial Liability. The amortisation cost or FVTOCI or FVTPL is based on the STPI model of the Company. In the given case, the company intends to repay the fixed principal and interest at due dates & STPI model meets the criteria of amortised cost. Hence, the convertible note should be classified as Financial Liability at Amortised cost.

Standard further requires application of EIR- Effective rate for recording finance cost.

In the given case there is no cost involved in raising the converible note, EIR is equal to coupon rate i.e 5%. Accordingly, the Company shall record interest as finance cost amounting to USD 500,000 i.e. 1million *5% in statement of profit and loss.