September 17, 2013 at 10:05 pm #140709perfecta1Member
Please, please,please could someone help me to understand how to do questions about financial instruments.
This is question from 2008 exam and I really don’t get it
Pingway issued a $10 million 3% convertible loan note at par on 1 April 2007 with interest payable annually in
arrears. Three years later, on 31 March 2010, the loan note is convertible into equity shares on the basis of $100 of
loan note for 25 equity shares or it may be redeemed at par in cash at the option of the loan note holder. One of the
company’s financial assistants observed that the use of a convertible loan note was preferable to a non-convertible
loan note as the latter would have required an interest rate of 8% in order to make it attractive to investors. The
assistant has also commented that the use of a convertible loan note will improve the profit as a result of lower interest
costs and, as it is likely that the loan note holders will choose the equity option, the loan note can be classified as
equity which will improve the company’s high gearing position.
The present value of $1 receivable at the end of the year, based on discount rates of 3% and 8% can be taken as:
End of year 1 0·97 0·93
2 0·94 0·86
3 0·92 0·79
show how the convertible loan note should be accounted for in Pingway’s income statement for the year ended 31 March 2008 and statement of financial position as at that date
could someone explain me please what means ‘interest rate of 8% in order to make it attractive to investors’ does it mean that the interest rate has been increased and at the end of period and 8% interest apply not 3%? Also this 3% interest is on value of loan so we will have to pay this interest every year from the amount that left to be repaid? ?
I’ve read technical article about financial instruments and itwas extremely helpful but still would like someone to go through this question with me. Thank you very much for help
September 18, 2013 at 5:52 am #140730MikeLittleKeymaster
8% is the effective rate ie the rate that would have to be paid if the loan note did not have the equity option. So 8% is the finance charge which should be reflected in the Statement of Income. That thus negates the statement from the assistant about profits being “higher because the interest amount is lower”
The instrument you have described is called a “mixed” instrument and has elements of both loan and equity. The accounting treatment is to value both elements and treat them accordingly. However, it’s extremely unlikely that anyone could value the equity element so the technique is to compute the present value of ALL payments associated with the loan (interest and capital repayment), deduct that amount from the face value of the loan and the difference will be treated as equity
So now we have Dr Cash Credit Loan Account with the present value of the loan (using 3% to calculate the annual interest payment) and Credit Other Components of Equity Account with the missing amount.
As each year goes by, calculate 8% on the outstanding amount of the loan and that is the finance charge for the Statement of Income
3% of the face value is to be paid in cash as loan interest. The difference between 8% of the brought forward obligation and the 3% interest payment is added to the obligation and carried forward into the next year
So, Dr Finance Charges Cr Cash with the 3% interest payment and
Dr Finance Charges Cr Loan Account with the difference between 8% of the brought forward obligation less 3% of the face value of the loan
September 19, 2013 at 8:35 pm #140888perfecta1Member
first of all sorry to b complete pest. I am still sitting and trying to understand the whole thing about convertible loans and Itried to focus on accounting entries first and then understand why accountant’s assumptions were incorrect.
I know how to calculate liability part and equity part in this question.
they are 8674 and 1326 respectively. Also i know why we have to charge 693290 finance cost in statement of profit and loss. but all this is in first year.
Could you tell me what will be the charge in finance costs and ammounts in SOFP in second year. I think that this would be:
CR equity 1326 (remains unchanged)
CR liabilities (9067.92 = 8674×1.08-10000×0.03)
and finance costs 1025.434 (9067.92x 0.08 +10000x 0.03)
and in 3rd year this would be
CR equity 1326
cr liability (9493*1.08-300)= 9952.44
and finance costs would be 9952.22*0.08 +300= 1096.2
I didn’t find any question prctice where it is required to calculate finance ocsts in 2nd and 3rd year hence my question.
Also is that true that after this 3 years period Following accounting entry will be required to account for the conversion of loan into shares after three years:
and this would be
DR laibility 10000
DR share option 1326
CR company shares 10000
CR share premium 1326
or this accounting is for bonds on maturity only?
September 20, 2013 at 7:11 pm #140935MikeLittleKeymaster
The second year’s finance charge would be 8% x 8,764
The third year finance charge would be 8% x (1.08% x 8,764) (I don’t have a calculator with me!)
The transfer of 1,326 seems ok to me
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