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An entity issues 2,000 convertible $1,000 bonds at par on 1/1/17. Interest is payable annually in arrears at a nominal interest rate of 6%. The prevailing market rate of interest at the date of issue of the bond was 9%. The bond is redeemable 31/12/19.
Calculate the amount that will be included in financial statements on:
1) initial recognition
2) during the first yearSolution:
1) Inital recognition
PV of principal = $2,000,000 x 0.772 (3 y, 9% discount factor) = $ 1,544,000
PV of interest = $120,000 x 2.531 (3y, cumulative, 9% discount factor) = $ 303,720
Total liability component = $ 1,847,720 [a]
Equity component = $ 152,280 [b]
Proceeds of the issue = [a] + [b] $ 2,000,0002) During first year
Initial recognised liability = $ 1,847,720
Interest for the year (to P+L) = $1,847,720 x 9% = $ 166,295
Cash interest paid = $2,000,000 x 6% = $ (120,000)
Year-end liability = $ 1,894,015My questions:
a) Why there is no treatment for the equity component after the 1st year? Shouldn’t it be reviewed at year end?
b) What should be the treatment if the interest was not paid in arrears? I actually did not understand the mechanism of calculation of the interest in arrears.
Thanks a million!
Once you have calculated the equity element at the inception of the agreement, that’s it!
The present value of the debt is credited to the loan and the balance difference between that present value of the debt when compared with the face value of the loan is the equity element credited to “other components of equity” and there it shall stay forever more!
Interest paid in arrears? If you think about this logically ALL interest is paid in arrears …
… except in those situations where it is stated to be paid in advance but even then, ignoring for one moment the very first payment, interest is paid in arrears
Consider this:
Loan taken on 1 January, 2004 $40,000
Interest at 10% paid in arrears
(I’m ignoring the loan repayment – I don’t need it to illustrate the point)
31 December, 2004 pay whatever is the capital amount + interestNow what if the interest is paid in advance?
Loan taken on 1 January, 2004 $40,000
Interest at 10% paid in advance
(I’m ignoring the loan repayment – I don’t need it to illustrate the point)
1 January, 2004 pay a capital amount? Maybe, but that simply reduces the amount of loan outstanding
Pay interest amount? Unlikely – you only borrowed the money 2 minutes ago!So that first payment of whatever amount is all capital and reduces the amount borrowed
The next payment in this agreement pays some capital and the interest accrued on that reduced level of borrowing and, even though the agreement may say it’s payable in advance, it’s actually paid in arrears, isn’t it? Surely 1 January, 2005 payment date is no different than 31 December, 2004
Yes, it affects the financial statements particularly where it’s a 31 December year end but that’s all
Look at the examples of Giedrius and Giedruola in the leases chapter of the free F7 course notes and try to follow those through
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