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DH Ltd is a company which manufactures and sells computer hardware. In 2021 the company recorded a record level of sales and is predicting a further increase in 2022. Based on this, DH Ltd decided to distribute part of its retained earnings to its owners, in the form of dividends, during 2021. A private equity investor is considering the purchase of a 20% holding in DH Ltd. The investor already holds a controlling interest in SW Ltd, a company which produces and sells computer software. The following are the 2021 draft financial statements of DH Ltd. DH Ltd: Income Statements for the years 2021 2020 ended 31st December: '000 '000 Sales 11,200 9,750 Cost of goods sold (8,460) (6,825) Gross Profit 2,740 2,925 Expenses (2,275) (2,605) Profit Before Interest and Tax 465 320 Finance Costs (60) (50) Corporation Tax (35) (25) Profit After Tax 370 245 DH Ltd: Statements of Financial Position as at 31st December: Assets Non-current Assets Current Assets Inventories Trade Receivables Cash Total Assets Equity and Liabilities Current Liabilities Trade Payables Bank Overdraft Corporation Tax Non-Current Liabilities: Debentures Equity Ordinary Share Capital Retained Earnings Total Equity and Liabilities 2020 '000 1,850 1,430 640 490 1,230 1,080 80 120 1,950 1,690 3,800 3,120 750 690 110 80 95 75 955 845 800 600 1,800 800 245 875 2,045 1,675 3,800 3,120 2021 '000 A table of accounting ratios for SW Ltd (for 2021) and DH Ltd (for 2021 and 2020) is provided below: SW Ltd DH Ltd DH Ltd Ratios 2021 2021 2020 Return on Capital Employed, ROCE (%) 18.5 15.7 13.6 Gross Profit Margin (%) 35.2 24.5 30.0 Net Profit Margin (%) 4.7 4.2 3.3 Net Asset Turnover (times) 3.9 3.8 4.1 Non-Current Asset Turnover (times) 6.0 6.1 6.8 Current ratio 2.0 2.0 2.0 Inventory Turnover (days) 20 28 26 Receivables (days) 52 40 40 Payables (days) 49 32 37 Interest Cover 5.50 7.75 6.40 Gearing [Debt/Capital Employed] (%) 32.7 30.8 28.9 Note: bank overdraft is treated as part of debt in above ratio calculations After reviewing the 2021 draft financial statements for DH Ltd the auditors pointed out the following to the directors: "On 1 January 2021 DH Ltd received 1m in cash by issuing 10,000 4% convertible bonds with a par value of 100. Each bond is redeemable in three years' time, on 31 December 2023, either for cash (at par) or convertible into four shares, at the option of the holder. Interest is payable annually in arrears. The market rate of interest for similar debt without the conversion option is 12%. On the date of issue, the business recorded the receipt of 1m as equity (i.e.: Dr cash; Cr equity). The payment at the year-end of 40,000 (4% of the par value of the convertible bonds) is recorded as dividends in the statement of changes in equity (i.e.: Dr Dividends; Cr Cash). These are the only two entries made relating to the bonds". Required: a. Explain, by applying the definitions of debt and equity, how the auditors would recommend that DH Ltd should account for the initial recognition of the convertible bonds on 1 January 2021, and the subsequent transactions relating to the bonds for the year ended 31 December 2021. Including relevant calculations, summarise the corrections (journal adjustments) to ensure the financial statements meet with reporting requirements. (Ignore the effects of tax). (14 marks) b. Using the necessary adjustments relating to task (a), recalculate the 2021 Gearing and Interest Cover ratios affected by the proposed adjustment for DH Ltd. (6 marks) c. Prepare a report for the private equity investor, evaluating the performance of DH Ltd and its investment potential. Your discussion should also consider the controlling interest that the investor holds in SW Ltd as well as its performance. (25 marks) d. The borrowing of DH Ltd is subject to financial covenants tested on a yearly basis. The first covenant is an interest cover covenant. The second covenant is a gearing covenant. Calculate and briefly comment on the performance of DH Ltd in relation to these covenants for 2021, if the minimum threshold for the interest cover covenant is 3.5 and the maximum covenant for gearing is 50%. (6 marks) e. Briefly describe the three hypotheses from Positive Accounting Theory. Based on the information provided above, discuss which of the three hypotheses can be more relevant in helping us explain the directors' accounting treatment in the draft financial statements of the convertible bond from DH Ltd. (9 marks)