Compound financial instruments

Compound financial instruments – An incredible shift in accounting concepts

Compound financial instruments contain elements which are representative of both equity and liability classification.

A common example is a convertible bond, which typically (but not always, see ‘2 Convertible bonds‘ below) consists of a liability component in relation to a contractual arrangement to deliver cash or another financial asset) and an equity instrument (a call option granting the holder the right, for a specified period of time, Compound financial instruments to convert the bond into a fixed number of ordinary shares of the entity).

Other examples of possible compound financial instruments include instruments with rights to a fixed minimum dividend and additional discretionary dividends, and instruments with fixed dividend rights but with the right to share in the residual net assets of the issuing entity on the entity’s liquidation.

1 Financial instruments with payments based on profits of the issuer

As discussed in ‘Financial instruments with payments based on profits of the issuer‘, an obligation to pay interest or dividends linked to profits of the issuer is a contractual obligation to deliver cash, which therefore meets the definition of a financial liability. Compound financial instruments

Some instruments that include such an obligation also include an equity component. For example, the contractual arrangements might make clear that the obligatory payments are a minimum and that additional, discretionary dividends might be paid. Such a feature meets the definition of an equity component since: Compound financial instruments

  • there is no obligation to deliver cash; and Compound financial instruments
  • it represents an interest in the residual assets of the issuer, after deducting all of the liabilities (IAS 32 11). Compound financial instruments

An equity component should be identified only if the discretionary feature has substance. It should not be presumed to exist (since, in theory, the issuer of any instrument could decide to make additional, discretionary payments). Compound financial instruments

As with all financial instruments within the scope of IFRS 9, the liability should initially be recorded at its fair value. Subsequently, the instrument is measured in accordance with IFRS 9 at amortised cost, using the effective interest method or subject to the own-use exception at fair value through profit or loss. Compound financial instruments

2 Convertible bonds

Many convertible bonds are compound instruments. However, a common misconception is that a convertible bond is always a compound financial instrument. In fact, a convertible bond will only be a compound instrument where the component relating to conversion satisfies the requirements of the ‘fixed for fixed‘ test. Compound financial instruments

Illustration – Foreign currency denominated convertible debt

A UK company whose functional currency is pounds sterling issues a convertible bond which is denominated in US dollars.

The fact that the bond is denominated in a foreign currency means that the conversion component fails the fixed for fixed test, as a fixed amount of foreign currency is not considered to represent a fixed amount of cash ( see ‘Contracts to be settled by a fixed number of own equity instruments in exchange for a fixed amount of foreign currency‘).

The key is to carefully examine the terms of each financial instrument to determine whether separate components exist and, where they do, whether they are equity components or liability components.

The following table illustrates the importance of the ‘fixed for fixed‘ test in relation to conversion rights:

Do conversion rights pass the ‘fixed for fixed’ test

Accounting requirements Compound financial instruments

Yes

Compound financial instruments

  • Instrument is treated as a compound instrument Compound financial instruments
  • Liability and equity instruments split on inception Compound financial instruments
  • Equity element is not remeasured Compound financial instruments

No

Compound financial instruments

Compound financial instruments

  • Instrument is a hybrid instrument containing a host debt instrument with a conversion right (an embedded derivative) – see ‘5 Hybrid instruments‘ below. Compound financial instruments
  • The instrument is split on inception (unless the conversion option is closely related to the host instrument). Where split, both elements are carried as liabilities Compound financial instruments
  • Where separately recognised, the embedded derivative must be separately recognised at fair value through profit and loss

3 Split accounting for a compound financial instrument

IAS 32 requires the principle of substance over legal form to be applied in accounting for compound financial instruments. This involves separating the compound financial instrument into its separate components on initial recognition, a process which is often referred to as ‘split accounting’.

Taking the example of a convertible bond, split accounting is performed by first determining the carrying amount of the liability component. This is done by measuring the net present value of the discounted cash flows of interest and principal, ignoring the possibility of exercise of the conversion option. The discount rate is the market rate at the time of inception for a similar liability that does not have an associated equity component.

The carrying amount of the equity instrument represented by the conversion option is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.

Illustration – Compound instrument – convertible bond

Entity A issues 1,000 convertible bonds on 1 July 2008 at par value of CU 1,000 each, giving CU 1m proceeds. The bonds have a three-year term and interest at 6% is paid annually in arrears. The bonds are convertible at the option of the holder, at any time until maturity, at a rate of 250 ordinary shares per bond. The prevailing market rate of similar bonds, without the conversion feature, is 9% per year.

The values of the liability and equity components are calculated as follows:

Amounts in CU

Compound financial instruments Compound financial instruments Compound financial instruments Compound financial instruments Compound financial instruments Compound financial instruments Compound financial instruments Compound financial instruments Compound financial instruments Compound financial instruments Compound financial instruments

Present value of principal payable at the end of 3 years (CU 1m discounted at 9% for 3 years)

772,183

Present value of interest payable in arrears for 3 years (CU 60,000 discounted at 9% for each of 3 years)

151,878

Total liabilities component

924,061

Proceeds of bonds issue

1,000,000

Residual equity component

75,939

In subsequent years, the profit and loss account is charged with interest of 9% on the debt instrument. Assuming a June year-end the accounting effect may be summarised as follows, assuming in this case that the bond is redeemed for cash rather than converted at the end of its term:

Amounts in CU

Cash movement from issue/ interest/

redemption

Interest charge at 9%

Liability

Equity

01/07/08

1,000,000

924,061

75,939

30/06/09

-60,000

83,165

947,226

75,939

30/06/10

-60,000

85,250

972,476

75,939

30/06/11 (pre redemption)

-60,000

87,524

1,000,000

75,939

30/06/11 (redemption)

-1,000,000

75,939

If the holder had exercised the option to convert at 30 June 2011, the carrying value at that time would have been transferred to equity rather than being repaid in cash (see IAS 32 AG32).

The split of the instrument between debt and equity and the amount of the respective components is determined on initial recognition and is not altered subsequently to reflect the likelihood of conversion of the instrument.

Another example of a compound instrument could be a non-redeemable preference share with an obligation to pay a contractual dividend but where in addition, there is also a contractual right to participate in further discretionary dividends. Such an instrument would be split accounted for as follows:

Illustration – Non-redeemable preference shares with obligation to pay dividends at less than market rates

Entity A issues 1,000 non-redeemable preference shares at par of CU 1 each, but the shares pay dividends of only 1% per annum (which is below the market rate of 8%). This amounts to an obligation to pay CU 10 per annum. In addition, the preference shares rank equally alongside ordinary shares in a winding up and the preference shares have voting rights. The preference shares also carry the possibility of discretionary dividends (ie in addition to the 1% obliged dividend/interest).

The CU 10 per annum dividend obligation meets the definition of a liability, but an equity component also exists as a result of the possibility of receiving discretionary dividends and participating in the net assets of the company should the company be liquidated. The shares are therefore compound financial instruments.

The liability component is based on the net present value at the time of inception of the CU 10 obligation for the annual dividend. This is calculated using the market rate of interest of 8% for a debt instrument without an equity component, giving CU 125 (CU 10 / 8%). The remainder of the proceeds received for issuing the shares would then be allocated to equity. The initial recognition of the transaction is:

Cash

CU

CU

Cash

1,000

Financial liability non-redeemable preference shares debt

125

Equity share capital

875

The annual dividend/interest of CU is charged to profit or loss as interest expenses, any additional dividend is recorded within shareholders’ equity.

4 Compound instruments containing embedded non-equity derivatives

In the above example, the issuer does not have an option (at its discretion) to force early repayment. Such an option would be an embedded derivative (see definition, above).

Where a compound instrument contains another embedded derivative in addition to the holder’s conversion option, the value of the additional embedded derivative must be allocated to the financial liability component (IAS 32.31). This is done using the same principles as for a normal compound financial instrument – the liability component is established by measuring the value of a liability with similar terms (including the existence of a similar embedded derivative) but without the holder’s conversion option.

The equity component is then arrived at by deducting the liability component calculated above from the fair value of the instrument as a whole.

Having performed this calculation, a further assessment must be made of whether the embedded derivative is closely related to the host debt contract. This is in accordance with the normal requirements in IFRS 9 B4.3.2 for embedded derivatives to be accounted for separately if they are not considered to be closely related to the host contract. This assessment is made before separating the equity component.

5 Hybrid instruments

A financial instrument containing an embedded derivative which does not meet the definition of equity is referred to as a hybrid instrument.

Illustration – Foreign currency denominated convertible debt

The convertible debt instrument denominated in a foreign currency discussed in ‘2 Convertible bonds‘ is an example of a hybrid instrument.

The conversion component does not meet the definition of equity as a fixed amount of foreign currency is not considered to represent a fixed amount of cash (see ‘4.6.1 Contracts to be settled by a fixed number of own equity instruments in exchange for a fixed amount of foreign currency’, above). The term ‘hybrid instrument’ indicates that the instrument contains a host debt contract and an embedded derivative liability (the written call option over the entity’s own shares).

As in ‘4 Compound instruments containing embedded non-equity derivatives‘ above, an assessment of whether the embedded derivative is closely related to the host contract is required. Unless the embedded derivative is closely related to the host contract, it should be separated out from the host contract and measured at fair value. As an alternative, however, the entity may choose to fair value the entire instrument and so avoid the practical problems in having to separate out the embedded derivative component from the host contract.

6 Conversion of a convertible bond

On conversion of a convertible bond at maturity, the liability element relating to the convertible bond should be derecognised and recognised as equity. The original amount recognised in respect of the equity component remains in equity (although it may be transferred from one line item to another within equity). There is no gain or loss on conversion at maturity.

6.1 Early settlement of a convertible bond

When a convertible bond or other form of compound instrument is extinguished before its maturity date, the issuer should allocate the consideration and any transaction costs for the repurchase or redemption to the liability and equity components of the instrument at the date of settlement.

In allocating the consideration paid (and the transaction costs) to the separate components, the issuer applies the same method as for the original allocation of the issue proceeds to the liability and equity components. In other words, the issuer starts by allocating the settlement price to the remaining liability, and allocates the residual settlement amount to the equity component. It determines the fair value of the remaining liability using a discount rate that is based on circumstances at the settlement date. This may differ from the rate used for the original allocation.

Once this allocation has been performed, any resulting gain or loss should be treated in accordance with the accounting principles that apply to the related component.

This means that a loss is recorded in profit or loss to the extent that the amount of the consideration allocated to the liability component exceeds the carrying amount of the liability component at the date of early settlement (and vice versa). In contrast, the amount of consideration allocated to equity is recorded in equity. No gain or loss is recorded in respect of the equity component. Any remaining balance in relation to the equity component may be reclassified to another component of equity.

Illustration – Issuer settles convertible bond by early repayment

The details are the same as in the first example. However on 30 June 2010, Entity A tenders an offer of CU 1.1m (after the payment of the interest due on 30 June 2010) to the convertible bondholder to extinguish the liability and conversion rights, and the holder accepts.

IAS 32 requires that the amount paid (of CU 1.1m) is split by the same method as is used in the initial recording. However at 30 June 2010, the interest rate has changed. At that time, Entity A could have issued a one-year (ie maturity 30 June 2011) non-convertible bond at 5%. As set out in the earlier example 1, the carrying value of the liability at 30 June 2010 is CU 972,476.

The split of the CU 1.1m paid is as follows (Amounts in CU):

Present value of principal payable at 30/06/11 in one year’s time (CU 1m discounted at 5% for 1 year)

952,381

Present value of interest payable(CU 60,000 at 5% in one year’s time)

57,142

Total liability component

1,009,523

Proceeds – total fair value

1,100,000

Residual – equity component

90,477

The amount paid allocated to the liability element is CU 1,009,523. This compares to a book value of the liability at that date of CU 972,476, so a loss of CU 37,047 is reflected in the profit and loss account. The CU 90,477 of the “redemption” related to equity is debited to equity.

6.2 Amendment of the terms of a compound instrument to induce early conversion

An entity may amend the terms of a convertible instrument to induce early conversion, for example by offering a more favourable conversion ratio or paying other additional consideration in the event of conversion before a specified date.

Where this is the case, the difference between the fair value of the consideration the holder receives on conversion of the instrument under the revised terms and the fair value of the consideration the holder would have received under the original terms is recognised as a loss in profit or loss.

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