Question

Question One The directors of QWE are considering different forms of finance to fund an acquisition. They have been advised to raise finance via an issue of convertible bonds however they are not sure what impact this would have on the financial statements. They are looking to issue 3% convertible bonds with a nominal value of R20 million and a four year term. They are particularly keen to keep their finance costs as low as possible in the statement of profit or loss and therefore are attracted to this form of finance because of the low interest rate of 3%. They have been told that the market rate of interest for similar bonds with a five year term but no conversion option is 8%. Required: Explain how this convertible instrument would be initially recorded in the financial statements of QWE in accordance with IAS 32 Financial Instruments: Presentation and subsequently measured in accordance with IAS 39 Financial Instruments: Recognition and Measurement in the financial statements. Note: there is no need to perform any calculations.

Answer 1

A convertible bond creates both an equity and a debt instrument.

On initial recognition(in accordance with IAS 32 Financial Instruments: Presentation) - the debt element will be measured at fair value i.e. the present value of the future cost flow, with the equity element representing the balancing figure. Transaction cost, if any, have to split proportionately between the debt and equity elements. The value ascribed to the equity element is the balancing figure.

On subsequent measurement(in accordance with IAS 39 Financial Instruments : Recognition and Measurement) - interest expense will be charged using 8%. The difference between interest paid and interest charged will be added to the liability component.