- 15 Marks
Question
On 1 July 2010, Union Conglomerate Ltd issued 20,000 8% Debentures at N97.50. The security is redeemable in five years’ time. The interest on the Debentures is payable bi-annually on 30 June and 31 December. On 31 December 2010, the Company’s year-end date, the Debentures were quoted on the Nigerian Stock Exchange for N96.00.
The company accountant has suggested each of the following as possible valuation bases for reporting the Debentures liability on the Balance Sheet as at 31 December 2010:
(i) Face value of the Debentures.
(ii) Face value of the Debenture plus interest payment for five years.
(iii) Market value on the Balance Sheet as at the year end.
Required:
(a) Determine the face value of the Debentures and the proceeds accruing to the company. (2 marks)
(b) Determine the amount and explain the nature of the differences between the face value and the market value of the Debentures on 1 July 2010. (4 marks)
(c) Distinguish between nominal and effective rates of interest. (3 marks)
(d) Determine the nominal interest payable on the Debentures for the year ended 31 December 2010. (2 marks)
(e) State arguments for or against each of the suggested alternatives for reporting the Debentures liability on the Balance Sheet as at 31 December 2010. (4 marks)
Answer
(a) Face value of the Debentures and Proceeds:
- Face Value: N100 × 20,000 = N2,000,000
- Proceeds: N97.50 × 20,000 = N1,950,000
(b) Differences between Face Value and Market Value: The difference between the face value and the market value of the debentures is N50,000. This is as a result of discount allowed on the issue on the debentures. Discount on debentures attracts investors.
(c) Nominal and Effective Rates of Interest:
- Nominal rate is the interest rate stated on the debenture (8% per annum on N2,000,000).
- Effective rate takes into account the market price of the debentures. The effective interest rate would be based on the actual proceeds (N1,950,000), making the real return higher than the nominal rate due to the discount.
(d) Nominal Interest Payable for the Year:
- N2,000,000 × 8% = N160,000
- Half-year interest (for 6 months): N80,000
(e) Arguments for and Against Valuation Methods:
- Face Value: Shows the amount that will be repaid at maturity, offering clarity for investors regarding the obligation.
- Face Value + Interest: Overstates the liability since interest payments are spread over time and not due immediately.
- Market Value: Reflects the current financial market conditions, providing a more realistic view of the liability based on market prices.
- Tags: Debentures, Financial Reporting
- Level: Level 1
- Topic: Bad and Doubtful Debts
- Series: NOV 2011
- Uploader: Theophilus