Raising of Funds: Step Up Bonds vs Convertible Bonds

High PG Limited is proposing to acquire further funds from the market in the form of debts or convertible equity whichever is beneficial. Two options have been explored: (a) Raising funds through issue of step up bonds with interest rates or coupon rates of 8%, 10% and 12%. (b) Convertible bonds which are convertible into equity of 15 million shares at the end of 3 year from settlement date. The article discusses the accounting treatment and impact on balance sheet of both options.

AYB200 Semester 2 2018
BUSINESS REPORT
RAISING OF FUNDS
FINANCIAL ACCOUNTING AYB200 SEMESTER 2 2018
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:
(a) 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;
(b) 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)
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AYB200 Semester 2 2018
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
Repaymen
t
15000000 1/1.1^3 0.75131 11269722.01
Present Value 13134861.01
Yea
r 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 1313486
1.01
13134861.01*1
0%
1313486.10
1 750000 13698347.11
2 31-12-2020 1369834
7.11
13698347.11*1
0%
1369834.71
1 750000 14318181.82
3 31-12-2021 1431818
1.82
14318181.82*1
0%
1431818.18
2 750000 15000000
Treatment under two options under books of account
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AYB200 Semester 2 2018
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.
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AYB200 Semester 2 2018
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.
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AYB200 Semester 2 2018
Bibliography
Financial Instruments. (2014, December). Retrieved September 3, 2018, from www.aasb.gov.au:
https://www.aasb.gov.au/admin/file/content105/c9/AASB9_12-14.pdf
Financial instruments. (2018). Retrieved September 3, 2018, from home.kpmg.com:
https://home.kpmg.com/.../aasb-9-financial-instruments-transition-practical-
guide.htmlwww.aasb.gov.au/admin/file/content105/c9/AASB9_12-14.pdf
Ghose, K. (n.d.). Convertible instruments. Retrieved September 3, 2018, from www.ey.com:
https://www.ey.com/Publication/vwLUAssets/EY-chapter-8-concertible-instruments/%24FILE/EY-
chapter-8-concertible-instruments.pdf
Martin, R. (2018, January 10). Guide to Convertible Debt . Retrieved September 3, 2018, from
www.rsm.global: https://www.rsm.global/australia/insights/ifrs-news/guide-convertible-debt
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