Question

Krazy Kiwis Inc. issued $6 million of 10-year, 9% convertible bonds on June 1, 2017. These bonds were issued at 98 plus accrued interest. The bonds were dated April 1, 2017, with interest payable April 1 and October 1. Bond discount is amortized semi-annually. Similar bonds without the conversion privileges would have sold at 97 plus accrued interest. On April 1, 2018, $1.5 million of these bonds were converted into 30,000 common shares. Accrued interest was paid in cash at the time of conversion but only to the bondholders whose bonds were being converted. Assume that the company follows IFRS.

Required:

1. Prepare the entry to record the issuance of the convertible bonds on June 1, 2017.

2. Prepare the entry to record the interest expense at October 1, 2017 by pro-rating the number of months. Assume that interest payable was credited when the bonds were issued.

3. Prepare the entry(ies) to record the conversion on April 1, 2018. (The book value method is used.) Assume that the entry to record amortization of the bond discount and interest payment has been made.

4. What do you believe was the likely fair value of the common shares as at April 1, 2018?

Answer 1

Part 1

Date	account titles and explanation	debit	credit
June 1, 2017	cash ((6000000*0.98)+90000)	5970000
	Bonds payable (6000000*0.97)		5820000
	Interest payable (6000000*9%*2/12)		90000
	Contributed surplus - conversion rights (balancing figure)		60000

Part 2

Using financial calculator effective interest rate is 4.7354%

Date	account titles and explanation	debit	credit
October 1,2017	interest payable	90000
	Interest expense (balancing figure)	183734
	Bonds payable (5820000*4.7354%*4/6)-(6000000*4.5%*4/6) Cash (6000000*9%/2)		3734 270000

Part 3

Date	account titles	debit	credit
April 1, 2018	bonds payable (1500000-42622)	1457378
	Contributed surplus - conversion rights (60000*25%)	15000
	Common Stock		1472378

Calculations :

Discount related to 25% ofthe bonds ($180,000 X .25)$45,000

Less discount amortized[($3,734 + ($5,820,000 + $3,734) X 4.7354% – $270,000)] X .25 2,378

Unamortized bond discount $42,622

Actual proceeds when bonds sold $5,880,000

Value of bonds only 5,820,000

Value of conversion rights 60,000

Proportion converted_ _25%

Value of rights converted $15,000

Part 4

The bondholders would only be motivated to convert bonds into common shares if they perceived an increase in the value of their investment, and if they would get common shares with a fair value higher than the fair value of the bonds that were given up in the conversion. The book value of what they gave up at the time of conversion is shown in the entry above as $1,472,378 for 30,000 common shares. This works out to slightly over $49 per share. Likely the common shares are trading at an amount higher than $49 by a good margin. There should be an excess over the book value of $49 as the bondholders are giving up a steady cash inflow from the interest income obtained from the bonds in exchange for shares, which might not yield any dividends. This is especially true as continuing to hold the bonds provides a return in the form of interest, yet the option feature locks in the stock appreciation in favour of the holder – so the immediate opportunity for a gain must be considered.