Topic 2 PART BIssuance of Loan Capital

LEARNING OUTCOMEStudent will be able to understand :

1. Issue of debentures

2. Convertible loan capital (stock)

ISSUANCE OF LOAN CAPITAL

• Public co. can raise capital through issuance of liability such as debenture, convertible loan stock and redeemable preference shares.

• Co. obliged to pay debts when it fall due.• An issuance of debt instrument will involve

transaction costs.• Transaction costs incur in issuance of liability maybe

charged as an expense in income statement.• However, transaction costs that relate to the issue of

hybrid (compound) instrument, the transaction costs have to be allocated to the liability and equity components in proportion.

ISSUE OF DEBENTURES

Co. which issues debentures must keep a register of holders of debentures at the registered office.

Debentures may be issued at par, at premium or at discount.

Debentures issued are initially at cost less any issue cost, which is the fair value of the total consideration received from the issuance.

After initial recognition, debentures should be measured at fair value or amortised cost using the effective interest rate.

EXAMPLE 10 (PG 48)

A co. issues a 3% loan notes with nominal value of RM150,000 at a discount of 10%. Transaction costs incurred amounted to RM11,455.

Required:Discuss the accounting treatment.

AnswerThe amount of financial liability shown on the date of issue

will be RM123,455 which is arrived at as follows:

RMNominal value 150,00010% discount (10% x 150,000) (15,000)Issuance cost (11,455)

123,545

Journal entries

Accounting entries on issue of loan notes

Dr Bank RM 123,545

Cr Loan notesRM123,545

If the effective interest rate is 10%. What is the loan liability

shown in the statement of financial position at the end of year

1?

Year Opening Finance Interest Closing

balance costs paid balance

10% 3%

1 RM123,545 RM12,355 (RM4,500) RM131,400=10% x 123,545

=3% x 150,000 (Nominal

value)

CONVERTIBLE LOAN CAPITAL (STOCK)

Another form of raising loan capital is through the issue of convertible debt, also known as compound instrument.

• A convertible debt is normally issued attached with an option given to the holder to convert the debt into an equity instrument (usually ordinary shares) of the issuer during the term of the debt up till the maturity

• The transaction costs that relate to the equity components are shown as a deduction from equity and the portion relates to the liability components can be charged as an expense to the income statement.

EXAMPLE 11 (PG 49)

ABC issues 4,000 three-year term convertible loan stock on 1/1/2002 with a face value of RM1,000 per loan stock.

The total proceeds from the issue amount to RM4,000,000.

Interest is payable in arrears at a nominal rate of 6% per annum.

Each loan stock is convertible at any time up to maturity into 500 ordinary shares.

When the loan stock was issued, the prevailing market interest rate for similar debt without conversion options was 9%.

Required:

Discuss the accounting treatment.

Determine the liability component by calculating the present value of

the bond together with the amount interest payable on the bond,

using the discount rate 9% that is the prevailing market rate for

similar bonds with no conversion rights.

Years Interest rate 6% Discount rate 9% Amount

RM RM

1 240,000 0.91 =[1/(1.09)1] 218,400

2 240,000 0.84 =[1/(1.09)2] 201,600

3 240,000 0.77 =[1/(1.09)3] 184,800

3 (Principle) 4,000,000 0.77 =[1/(1.09)3] 3,080,000

Total liability component 3,684,800 Proceeds 4,000,000

Equity components 315,200

The balancing figure between the liability component and the proceeds from the issuance of the bond represents the equity component.

The split between the liability and equity components will be disclosed separately over the term of the convertible debt as the company will not be able to predict how many and when the loan stockholders may exercise their option to convert the loan stock into shares.

The issuer continues to have an obligation to make interest payment until conversion or maturity.

The liability amount is built up over the term of the loan stock to equal the nominal value of the loan stock on issue.

If the holder decide to convert all the debts into

ordinary shares upon maturity, the journal entries will appear

as below.

RM RM

Dr 6% convertible loan stock 4,000,000

Equity component 315,200

Cr Ordinary shares 2,000,000

Share premium 2,315,200