QUESTION 3

When an entity issues a financial instrument, it has to determine its classification either as debt or as equity. The result of the classification can have a significant effect on the entitys reported results and financial position.

1. Discuss the implications for a business if a substance approach is used for the reporting of convertible bonds. Explain what is meant by the term split accounting when applied to convertible bonds.

9. marks)

2. An entity issues a $200 million convertible bond that attracts interest of 5%. The market rate for an equivalent debt without the convertible option is 7%. The loan of $200 million is repayable in full after five years or convertible to equity.

Required:

Illustrate on how to split the convertible loan between debt and equity at inception.

8. marks)

3. An entity issues Perpetual Bond of $500 million in nominal value. The salient features of the Perpetual Bond are as follow:-

1. The Perpetual Bond has no fixed maturity date and the Company has an option to redeem all or part of the Perpetual Bond at the end of the fifth year and thereafter;
2. The Perpetual Bond carries a periodic distribution rate of 6% per annum;
3. Deferred periodic distribution, if any, will be cumulative but will not earn additional profits.

Required:

Discuss should the above instrument to be classified either as debt or as equity. Appropriate quotes from the relevant standard are expected to support your answer. (8 marks)

(Total: 25 marks)