Question:
Answer:
Introduction
High PG Limited is a company engaged in production activity with average return on the assets of the company being 8% and the debt cost for the company being 7%. The company is having negative retained earning implying heavy losses in the past but the company is turning profitable as it has a positive return on assets. High PG Limited operates in a competitive market environment and is in a expansionary phase. The company is proposing to acquire further funds from the market in the form of debts or convertible equity whichever is beneficial. The CFO of the company has asked me to chalk out the most efficient way of raising funds. In this regard, two options have been explored and detailed here-in-below:
- Raising funds through issue of step up bonds with interest rates or coupon rates of 8%, 10% and 12%. The tenure of bonds being 3 year with repayment of principal at maturity;
- Convertible bonds which are convertible into equity of 15 million shares at the end of 3 year from settlement date.
Journal Entries for Step up Bond and the explanation for such treatment
If the company propose to issue bonds as step-up bonds to finance the expansion process of the company,the following accounting treatment shall be meted out in the books (Refer Annexure-1). In terms of relevant paras of AASB 9 of Australian Accounting standard bond, the treatment of step-up with no conversion feature shall be simple with interest payment occurring at the end of the year and the same is transferred to profit and loss account as expense. Further, the debt instrument shall be treated as long term with repayment at the end of 3 years. Further, debt being a financial instrument to be precise a financial liability in terms of AASB 9 has to be valued at fair value. (Financial instruments, 2018)The market rates have been considered at 8%, 10% and 12% in respective years with no component of equity embedded in it.
Journal Entries for convertible Bond and the explanation for such treatment
If the company proposes to issue convertible bonds to finance the expansion process of the company, the following accounting treatment shall be meted out in terms of AASB 9 which is in alignment with IAS 32 Financial Instrument Presentation and IAS 39 Recognition and Measurement of Financial Instrument (Martin, 2018)
The issue of convertible debt instrument is treated as compound financial security. Thus, there has been a split between debt instrument and equity conversion option. Both of them are accounted separately. Further, the debt instrument is recognised at fair value under the initial stage and then amortised over the life of the asset using effective interest rate. The rate of interest has been taken @10% for the ease of computation. Further, the conversion option shall be either treated as equity or liability of financial nature. (Financial Instruments, 2014)
In addition, the treatment of the same shall be dependent on fixed for fixed test. On the basis of such test, it shall be decided whether the same shall be treated as equity or financial liability. (Ghose)The detailed computation has been provided here-in-below:
| Year | Date | Type of cash flow | Cash flow | Present value factor Calculation | Present value factor | Present Value | ||||
| 1 | 31-12-2019 | Coupon | 750000 | 1/1.1 | 0.90909 | 681818.1818 | ||||
| 2 | 31-12-2020 | Coupon | 750000 | 1/1.1^2 | 0.82645 | 619834.7107 | ||||
| 3 | 31-12-2021 | Coupon | 750000 | 1/1.1^3 | 0.75131 | 563486.1007 | ||||
| 3 | 31-12-2021 | Principal Repayment | 15000000 | 1/1.1^3 | 0.75131 | 11269722.01 | ||||
| Present Value | 13134861.01 | |||||||||
| Year | Date | Present Value of Liability | Interest Calculation | Effective Interest | Actual Interest payment | Value of Liability at the end of the year | ||||
| 1 | 31-12-2019 | 13134861.01 | 13134861.01*10% | 1313486.101 | 750000 | 13698347.11 | ||||
| 2 | 31-12-2020 | 13698347.11 | 13698347.11*10% | 1369834.711 | 750000 | 14318181.82 | ||||
| 3 | 31-12-2021 | 14318181.82 | 14318181.82*10% | 1431818.182 | 750000 | 15000000 | ||||
Treatment under two options under books of account
| Statement showing financial position under option 1 | |||
| 31-12-2019 (Extract) | |||
| Sl No | Patrticulars | Amount | Amount |
| I | Equity And Liabilities | ||
| (i) | Shareholders Funds | ||
| -Reserve and surplus | 10000000 | ||
| (ii) | Non-Current Liabilities | ||
| -Step up bonds | 15000000 | ||
| Statement showing financial position under option 2 | |||
| 31-12-2019 (Extract) | |||
| Sl No | Patrticulars | Amount | Amount |
| I | Equity And Liabilities | ||
| (i) | Shareholders’ Funds | ||
| -Reserve and surplus | 10000000 | ||
| -Conversion Premium | 1865139 | ||
| (ii) | Non-Current Liabilities | ||
| -Convertible bonds | 13698347 | ||
The above treatment has been carried out in terms of AASB 9 and IAS 32 and 39 of international accounting standard. Further, the treatment under option 1 is the simplest, however the same shall result in outflow of resources of the company at the end and shall have detrimental impact on the funds requirement of the company if the company is unable to generate substantial profits. However, judging bv the present scenario it may be profitable for the company to repay the debt by creating a sinking fund to the cause as the company is earning substantial profits and creating a sinking fund shall ease the paying back of debt post 3 years.
As far as option 2 is considered, the conversion option comes with a lower outflow of resources and no outflow of principal by 3 year end. However, the same involves a complex computation of fair value of debt and segregation of equity and liability component in terms of AASB 9 and the corresponding IAS applicable from 01-01-2018 in Australia.
The method involves use or issue of equity shares at the end of 3 year which shall have impact of dilution of stake of existing shareholders.
Impact on Balance sheet
Under option 1, the non-current liability is high for 2 years compared to option 2 which has lower non-current liability for 2 years.
Option 1 involves, higher outflow of resources impacting cash reserves of the company compared to option 2.
The equity component remains unchanged on account of debt under option 1. However, the same is impacted when convertible debt is issued.
Under option 1, return on asset ratio shall be favourable compared to option 2.However, return on equity ratio shall be favourable under option 2.
Option 2 shall have impact on the existing shareholders and involves dilution of the stake in the company by existing shareholders. Since , the company is earning good profits and is able to repay interest, option 1 shall be adopted as it does not have impact on the holdings of existing shareholders.
Bibliography
Financial Instruments. (2014, December). Retrieved September 3, 2018, from www.aasb.gov.au:
Financial instruments. (2018). Retrieved September 3, 2018, from home.kpmg.com:
Ghose, K. (n.d.). Convertible instruments. Retrieved September 3, 2018, from www.ey.com:
Martin, R. (2018, January 10). Guide to Convertible Debt . Retrieved September 3, 2018, from www.rsm.global:
