Question

On January 1, 2020, when the fair value of its common shares was $85 per share, Carla Vista Corp. issued $10 million of 7% convertible debentures due in 20 years. The conversion option allowed the holder of each $1,000 bond to convert the bond into 6 common shares. The debentures were issued for $10.5 million. The bond payment’s present value at the time of issuance was $8.3 million and the corporation believes the difference between the present value and the amount paid is attributable to the conversion feature. On January 1, 2021, the corporation’s common shares were split 2 for 1, and the conversion rate for the bonds was adjusted accordingly. On January 1, 2022, when the fair value of the corporation’s common shares was $149 per share, holders of 25% of the convertible debentures exercised their conversion option. Carla Vista Corp. applies ASPE, and uses the straight-line method for amortizing any bond discounts or premiums.

Assume, instead, that Carla Vista Corp. decides to retire the bonds early, on January 1, 2022, by paying cash of $2,765,000 to the bondholders. On that date, the fair value of a similar bond without the conversion feature is $870 per bond. Prepare the journal entry using the book value method. (Credit account titles are automatically indented when the amount is entered. Do not indent manually.)

Answer 1

The problem relates to compound financial instrument.

By definition, a compound financial instrument is a single security that possesses characteristics of both debt and equity.

IFRS 9 Financial Instruments prescribes splitting of such components by using residual value approach. This requires measurement of the debt component at its fair value with any excess proceeds allocated to equity. This is based on the fundamental principle that equity represents residual claim over firm assets.

(1) Entry to record issuance

(b) Entry to record conversion (book value method)