Question

Skysong Corporation issues 2,300 convertible bonds at January 1, 2019. The bonds have a 3-year life, and are issued at par with a face value of $1,000 per bond, giving total proceeds of $2,300,000. Interest is payable annually at 6%. Each bond is convertible into 250 ordinary shares (par value of $1). When the bonds are issued, the market rate of interest for similar debt without the conversion option is 7%.
1.Compute the liability and equity component of the convertible bond on January 1, 2019

2.Prepare the journal entry to record the issuance of the convertible bond on January 1, 2019

3.Prepare the journal entry to record the repurchase of the convertible bond for cash at January 1, 2019, its maturity date

Answer 1

Solution:

1. We can separate equity and liability components by the residual approach. In this approach we calculate the value of liability as the present value of interest and principal payments from the bonds and value of equity as the difference between proceeds from issuance of bonds and present value of interest and principal payments from the bonds.

Value of liability:

We calculate this by discounting the interest and principal payments from the bonds at the market rate of interest (7% given) with the assumption that conversion option is not available.

Year	Cash flow	Amount	Calculation	Present value factor	Present value
1	Coupon	138,000	(1/1.07^1)	0.934579	128971.96
2	Coupon	138,000	(1/1.07^2)	0.873439	120534.54
3	Coupon	138,000	(1/1.07^3)	0.816298	112649.11
3	Principal repayment	2,300,000	(1/1.07^3)	0.816298	1877485.12
					2,239,640.73

Coupon payment = 2300 bonds x 1000 x 6% = $ 138,000

So, present value = $ 2,239,640.73

Hence liability = 2,239,640.73

Equity component = Proceeds - Liability

= 2,300,000 - 2,239,640.73

= 60,359.27

2. Journal entry to record issuance of bonds :

Date	Journal	Debit	Credit
Jan 1, 2019	Bank	2,300,000
	Bonds Payable		2,239,640.73
	Share premium- Equity conversion		60,359.27
	(Being 2300 convertible bonds issued at 6% coupon rate and 3 years maturity)

3. Journal entry to record repurchase of bonds at maturity.

Date	Journal	Debit	Credit
Jan 1, 2022	Bonds Payable	2,300,000
	Bank		2,300,000
	(Being 2300 convertible bonds repurchased at maturity)

Bonds payable at maturity will become equal to face value as interest costs will be debited over the period and bonds payable will be credited at the market rate of interest negating the effect of discounting done earlier.