Question

P16.7 Cornwall Inc., a publicly accountable enterprise that reports in accordance with IFRS, issued convertible bonds for the first time on January 1, 2020. The $1 million of six-year, 10% (payable annually on December 31, starting December 31, 2020), convertible bonds were issued at 107. The bonds would have been issued at 97 without a conversion feature, and yielded a higher rate of return. The bonds are convertible at the investor's option.

The company's bookkeeper recorded the bonds at 107 and, based on the $1,070,000 bond carrying value, recorded interest expense using the effective interest method for 2020. He prepared the following amortization table, believing that the yield was 7%:

Date		Cash Interest (10%)		Effective Interest (7%)		Premium Amortization		Carrying Amount of Bonds
Jan. 1, 2020								$1,070,000
Dec. 31, 2020		$100,000		$74,900		$25,100		1,044,900

You were hired as an accountant to replace the bookkeeper in November 2021. It is now December 31, 2021, the company's year end, and the CEO is concerned that the company's debt covenant may be breached. The debt covenant requires Cornwall to maintain a maximum debt to equity ratio of 2.3. Based on the current financial statements, the debt to equity ratio would be 2.6. The CEO recalls hearing that convertible bonds should be reported by separating out the liability and equity components, yet he does not see any equity amounts related to the bonds on the current financial statements. He has asked you to look into the bond transactions recorded and make any necessary adjustments. He would also like you to explain how any adjustments that you make affect the debt to equity ratio.

Instructions

a. Determine the amount that should have been reported in the equity section of the statement of financial position at January 1, 2020, for the conversion right, considering that the company must comply with IFRS. Prepare the journal entry that should have been recorded on January 1, 2020.

b. Explain whether ASPE offers any alternatives that are not available under IFRS.

c.  Using (1) a financial calculator or (2) Excel functions, calculate the effective rate (yield rate) for the bonds. Round to five decimal places.

Answer 1

Answer:-

(a)      Entry at January 1, 2020 should have been:

          Cash ($1,000,000 X 1.07)............................................         1,070,000

                   Bonds Payable ($1,000,000 X .97).....................                                    970,000

                   Contributed Surplus—

                        Conversion Rights.........................................                                  100,000

           At the issuance of the convertible bond, the bookkeeper should have recognized the debt (bond) and conversion right (equity) components separately in the accounts.

           As the company is compliant with IFRS, the residual method, as illustrated in the corrected entry above, should have been used. Under IFRS, the debt component is measured first, with the residual value assigned to equity since it is a residual item.

(b)      ASPE does have an option to allow for the equity portion to be allocated zero, with all the proceeds being allocated to the debt component. If this option was available, the bookkeeper would be correct. However, this is an optional treatment and the correction noted in part (a) above is still in order as the company is a publicly accountable enterprise and must prepare financial statements in accordance with IFRS.

(c)      Using either a financial calculator or Excel the effective interest rate on the bonds is calculated as follows:

Excel formula =RATE(nper,pmt,pv,fv,type)

Using a financial calculator:

PV	$ 970,000
I	? %	Yields 10.70307 %
N	6
PMT	$ (100,000)
FV	$ (1,000,000)
Type	0