Question

Blossom Inc., a publicly accountable enterprise that reports in accordance with IFRS, issued convertible bonds for the first time on January 1, 2017. The $1 million of six-year, 10% (payable annually on December 31, starting December 31, 2017), convertible bonds were issued at 107, yielding 7%. The bonds would have been issued at 96 without a conversion feature, and yielding a higher rate of return. The bonds are convertible at the investor’s option.

The company’s bookkeeper recorded the bonds at 107 and, based on the $1,070,000 bond carrying value, recorded interest expense using the effective interest method for 2017. He prepared the following amortization table:

				Cash Interest		Effective Interest		Premium		Carrying Amount
Date				(10%)		(7%)		Amortization		of Bonds
Jan. 1,		2017								$1,070,000
Dec. 31,		2017		$100,000		$74,900		$25,100		1,044,900

You were hired as an accountant to replace the bookkeeper in November 2018. It is now December 31, 2018, the company’s year end, and the CEO is concerned that the company’s debt covenant may be breached. The debt covenant requires Blossom to maintain a maximum debt to equity ratio of 2.3. Based on the current financial statements, the debt-to-equity ratio would be 2.6. The CEO recalls hearing that convertible bonds should be reported by separating out the liability and equity components, yet he does not see any equity amounts related to the bonds on the current financial statements. He has asked you to look into the bond transactions recorded and make any necessary adjustments. He would also like you to explain how any adjustments that you make affect the debt to equity ratio.

Determine the amount that should have been reported in the equity section of the statement of financial position at January 1, 2017, for the conversion right, considering that the company must comply with IFRS.

Prepare the journal entry that should have been recorded on January 1, 2017

Using a financial calculator or computer spreadsheet functions, calculate the effective rate (yield rate) for the bonds.

Prepare a bond amortization schedule from January 1, 2017, to December 31, 2021, using the effective interest method and the corrected value for the bonds.

Prepare the journal entry dated January 1, 2018 to correct the bookkeeper’s recording errors in 2017. Ignore income tax effects.

Prepare the journal entry at December 31, 2018 for the interest payment on the bonds.

Answer 1

The following has to be considered while recognising financial liability of compound financial instrument

whether there is a contractual obligation to pay cash that the issuer cannot avoid. The answer is yes, as the issuer has to pay an annual cash coupon and could be required to repay the capital amount at the end of three years if the holder chooses not to exercise the conversion option

Whether the instrument has any characteristics that are similar to equity. The answer is yes as the instrument contains an option to be converted into equity instruments.

In such case fair value of similar bond without the option of conversion will become debt component and will have to be recorded as financial liability and residual amount will have to be recorded as equity.

Fair value of convertible bonds(issue value) - Fair value of non convertible similar bonds = Equity residual componenats

* Here similar bonds have to be understood as bonds of same rating with same terms and condition excepting conversion feature.

In the given case Bonds with conversion are issued at 107, similar bonds without conversion option could have issued at 96 so fair value of liability is 96 and equity component is 11

on January 1, 2017 the following entry should have been recorded

Bank Dr $1,070,000

To Liability - bonds Cr - $960,000

To Equity Cr - $110,000

In spreadsheet using IRR formula effective interest rate can be caluculated

Date $ Remarks

1-Jan-17 960 Liability compnent

31-Dec-17 -100 Coupon

31-Dec-18 -100 Coupon

31-Dec-19 -100 Coupon

31-Dec-20 -100 Coupon

31-Dec-21 -100 Coupon

31-Dec-22 -1100 Coupon + redemption value $100

10.94%

Yield rate is 10.94%

Below is the amortisation schedule of the bond

Date Opening Interest expenses Cash coupon Closing balance

31-Dec-17 960,000 105,062 100,000 965,062

31-Dec-18 965,062 105,616 100,000 970,678

31-Dec-19 970,678 106,231 100,000 976,909

31-Dec-20 976,909 106,913 100,000 983,822

31-Dec-21 983,822 107,669 100,000 991,491

31-Dec-22 991,491 108,509 100,000 1,000,000

On December 31, 2018 the following entry has to be passed

Interest expenses Dr 105,616

To Bank (cash coupon) Cr 100,000

To Liability bonds Cr 5,616