cheery Company follows IFRS for its financial reporting. On January 1, 2015 Cheery issued $250 million of 10-year convertible notes that pay interest at 5% annually. Investors pay $250 million for the notes even though the company's credit risk at the time implies a 10% interest rate for traditional debt of similar duration. When the cash flows associated with the debt are discounted at 10%, the resulting value is $175 million.
1. On Cheery's December 31, 2015 income statement how much interest expense will be recorded?
a. $25 million
b. $12.5 million
c. $17.5 million
d. $8.75 million
2. How much cash will Cheery pay for interest during 2015?
a. $25 million
b. $12.5 million
c. $17.5 million
d. $8.75 million
3. When Cheery records interest expense on December 31, 2015 the entry will include a:
a. debit to interest expense for $25 million.
b. credit to convertible notes payable for $12.5 million.
c. debit to convertible notes payable for $17.5 million.
d. credit to convertible notes payables for 5 million.
A
b
c
To answer these questions, we need to understand the terms of the convertible notes and how interest expense is calculated.
1. To determine the interest expense on Cheery's income statement for December 31, 2015, we need to calculate the interest based on the carrying value (book value) of the convertible notes. The carrying value is the initial amount of the notes minus any discount or plus any premium. In this case, there is a discount since investors paid $250 million for the notes even though the company's credit risk implies a higher interest rate than the stated 5%.
The discount represents the difference between the amount paid by investors and the fair value of the notes based on the implied interest rate. The discounted value of $175 million is the fair value at the time of issuance.
So, the interest expense would be calculated on the carrying value of $175 million, not the face value. Since the interest rate is 5%, the interest expense can be calculated as follows: $175 million * 5% = $8.75 million.
Therefore, the correct answer to question 1 is option (d) $8.75 million.
2. The cash paid for interest during 2015 would be based on the stated 5% interest rate and the face value of the convertible notes. The face value of the notes is $250 million, and the interest rate is 5%.
So, the cash paid for interest during 2015 can be calculated as follows: $250 million * 5% = $12.5 million.
Therefore, the correct answer to question 2 is option (b) $12.5 million.
3. When Cheery records interest expense on December 31, 2015, the entry will involve debiting the interest expense and crediting the convertible notes payable.
Since the interest expense is $8.75 million, the entry would be a debit to interest expense for $8.75 million. Since there is no information about a early repayment or early conversion, the notes payable would not be affected in this entry.
Therefore, the correct answer to question 3 is (a) debit to interest expense for $8.75 million.
1. To determine the interest expense recorded on Cheery's December 31, 2015 income statement, we need to calculate the interest payable for the year. The interest payable can be calculated by multiplying the outstanding principal amount of the convertible notes by the annual interest rate. In this case, the outstanding principal amount is $250 million, and the annual interest rate is 5%.
Interest payable = $250 million * 5% = $12.5 million
Therefore, the answer to question 1 is (b) $12.5 million.
2. The cash payment for interest during 2015 will be equal to the interest payable for the year. As calculated in question 1, the interest payable is $12.5 million.
Therefore, the answer to question 2 is (b) $12.5 million.
3. When Cheery records interest expense on December 31, 2015, the entry will include a debit to interest expense and a credit to convertible notes payable. The debit amount will be equal to the interest expense recorded, which is $12.5 million.
Therefore, the answer to question 3 is (a) debit to interest expense for $12.5 million.