5 Pingway issued a £10 million 3% convertible loan note at par on 1 April 2007 with interest payable annually in
arrears. Three years later, on 31 March 2010, the loan note is convertible into equity shares on the basis of £100 of
loan note for 25 equity shares or it may be redeemed in cash at par at the option of the loan note holder. One of the
company’s financial assistants observed that the use of a convertible loan note was preferable to a non-convertible
loan note as the latter would have required an interest rate of 8% in order to make it attractive to investors. The
assistant has also commented that the use of a convertible loan note will improve the profit as a result of lower interest
costs and, as it is likely that the loan note holders will choose the equity option, the loan note can be classified as
equity which will improve the company’s high gearing position.
The present value of £1 receivable at the end of the year, based on discount rates of 3% and 8% can be taken as:
3% 8%
£ £
End of year 1 0·97 0·93
2 0·94 0·86
3 0·92 0·79
Required:
Comment on the financial assistant’s observations and show how the convertible loan note should be accounted
for in Pingway’s profit and loss account for the year ended 31 March 2008 and balance sheet as at that date.
(10 marks)

5 Accounting correctly for the convertible loan note in accordance with FRS 25 Financial Instruments: Disclosure and Presentation
and FRS 26 Financial Instruments: Recognition and Measurement would mean that virtually all the financial assistant’s
observations are incorrect. The convertible loan note is a compound financial instrument containing a (largely) debt component
and an equity component – the value of the option to receive equity shares. These components must be calculated using the
residual equity method and appropriately classified (as debt and equity) on the balance sheet. As some of the proceeds of the
instrument will be equity, the gearing will not be quite as high as if a non-convertible loan was issued, but gearing will be increased.
However, if the loan note is converted to equity in March 2010, gearing will be reduced. The interest rate that would be applicable
to a non-convertible loan (8%) is representative of the true finance cost and should be applied to the carrying amount of the debt
to calculate the finance cost to be charged to the profit and loss account thus giving a much higher charge than the assistant
believes.
Accounting treatment: financial statements year ended 31 March 2008
Profit and loss account:
Finance costs (see working) £693,920
Balance sheet:
Creditors: amount falling due after more than one year
3% convertible loan note (8,674 + 393·92) £9,067,920
Capital and reserves
Option to convert £1,326,000
Working (figures in brackets in £’000)
cash flows factor at 8% present value £’000
year 1 interest 300 0·93 279
year 2 interest 300 0·86 258
year 3 interest and capital 10,300 0·79 8,137
–––––––
total value of debt component 8,674
proceeds of the issue 10,000
–––––––
equity component (residual amount) 1,326
–––––––
The interest cost in the profit and loss account should be £693,920 (8,674 x 8%), requiring an accrual of £393,920 (693·92 –
300 i.e. 10,000 x 3%). This accrual should be added to the carrying value of the debt.

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