ACCA Strategic Professional · Strategic Business Reporting (International) · Analysis and interpretation of financial and non-financial information and measurement of performance
Cedar Co has gearing measured as debt/(debt + equity). It issues a convertible bond and, under IAS 32, the conversion option is classified as equity, with the liability component recognised at the present value of cash flows at a market rate for non-convertible debt. Compared with treating the whole proceeds as debt, what is the effect on reported gearing and finance cost?
Gearing is lower and finance cost is higher. Under IAS 32 part of the proceeds goes to equity, reducing the liability, but the discounted liability is unwound at the effective interest rate, which exceeds the coupon, raising the finance charge.
- AGearing is higher and finance cost is lower
- BGearing is lower and finance cost is higherCorrect
- CGearing and finance cost are both lower
- DGearing and finance cost are both higher
Explanation
Splitting out the equity component reduces the liability, so debt and gearing are lower. The liability is accreted to redemption value at the effective rate, producing a higher finance cost than the coupon alone, which is the higher charge relative to treating the proceeds as all debt at the coupon. Therefore gearing is lower and finance cost higher.
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