Question

Financial Instruments

PP LLC issued at 10% three-year convertible bond (CB) at par worth 5,000,000 USD with 7% coupon. The terms of the convertible bond is that the holder of the bond, on the redemption date, has the option to convert the bond to equity shares at the rate of 100 shares with a nominal value of 2 USD per 100 USD debt rather than being repaid in cash. PP LLC accounted for the financial liability arising using amortized cost. The holder of the bond converted the liability into stocks at maturity.

Required:

Show relevant calculations/journal entries (initial recognition, subsequent measurement and conversion).

Answer 1

Initial Recognition

Assuming interest rate of a similar bond without the conversion option is 10% and with conversion option interest rate is 7% coupon rate( as given in the question )

Following are the accounting entries must be recorded upon initial recognition

Dr - Cash/Bank $5,000,000 (total Proceeds)

Cr - Liability $ 4,626,972 (Note 1 )

Cr - Share Options ( Equity ) $ 373,028 ( Balancing Figure)

Note 1:

Present value of future interest payments and principal using 10%

Year 1 : $ 350,000(interest) x [1/1.1] = $318,182

Year 2 : $ 350,000(interest) x [1/1.1^2] = $ 289,256

Year 3 : $ 350,000(interest) x [1/1.1^3] = $262,960

Year 3 : $ 5,000,000(interest) x [1/1.1^3] = $ 3,756,574

Total = 4,626,972

Subsequent Measurement

Interest expense will be charged using 10%. The difference between interest paid and interest charged will be added to the liability component as follows:

	Interest Expense		Liability
		$		$
Year1:	[4,626,972 x 10%]	462,697	[4,626,972 + 462,697 - 350,000*]	4,739,669
Year2:	[4,739,669x 10%]	473,967	[4,739,669+ 473,967 - 350,000]	4,863,636
Year3:	[4,863,636x 10%]	4,863,64	[4,863,636+ 4,863,64 - 350,000]	5,000,000

*$350,000 is the 7% nominal interest.

Maturity

Following accounting entry will be required to account for the conversion of bonds into shares after three years:

Dr - Liability		$5,000,000
Dr - Share Options (equity)		$373,023

Cr - Share Capital			$5,000,000
Cr - Share Premium			$373,023

Accounting Treatment

IFRS propose that the issuing company must separately identify the liability and equity components of convertible bonds and treat them accordingly in the financial statements.

Initially, the liability component is calculated by discounting the future cash flows of the bonds (interest and principle) at the rate of a similar debt instrument without the conversion option. The value of the equity component is the difference between the present value of the liability component of the convertible bond (as mentioned above) and the total proceeds from the issue of bonds. This is known as the residual approach to calculation of equity component which assumes that value of the share option is equal to the difference between the total issue proceeds of the convertible bonds and the present value of future cash flows using the interest rate of a similar debt instrument without the option to convert into shares.

Subsequently, Interest is charged to the income statement based on the effective interest rate, which is usually higher than the nominal rate, to reflect the true opportunity cost of the financial liability.

Upon maturity of the convertible bonds, the accounting treatment depends on whether the conversion option is exercised or lapsed. If the conversion option is not exercised, the company will have to pay the principal amount of the convertible bonds. Therefore, the outstanding liability may be simply de-recognized. If however, the conversion option is exercised, the company will have to issue shares to the bondholders. Hence, both liability and equity components of the convertible bonds will need to be de-recognized and replaced by share capital reserves as they are treated as consideration for the new shares issue.