Convertible debt option reserve

Convertible debt option reserve – A convertible instrument is dealt with by an issuer as having two ‘components’, being a liability host contract plus a separate conversion feature which may or may not qualify for classification as an equity instrument. When the conversion feature qualifies as an equity instrument it is recorded as a convertible debt option reserve.

The criteria to qualify as an equity instrument are:

  • There is no contractual obligation to pay cash that the issuer cannot avoid. The equity conversion feature can only be settled through the issue of equity shares, otherwise it will simply expire unexercised,
  • There is no obligation to issue a variable number of shares. If exercised, the option will result in the issue of a fixed number of shares,
  • There is no foreign currency element, as the issuer’s functional currency and the currency of the convertible instrument are the same.

When the initial fair value of a compound financial instrument is required to be allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component.

This example sets out the accounting approach for a convertible note in its simplest form, in which it contains a financial liability and a fixed-for-fixed equity conversion feature.

Entity A issues a note with face value of CU 1,000 which has a maturity of three years from its date of issue. The note pays a 10% annual coupon and, on maturity, the holder has an option either to receive a cash repayment of CU 1,000 or 10,000 of the issuer’s shares. The market interest rate for a note without a conversion feature would have been 12% at the date of issue.

Entity A incurred transaction costs of CU 100 in issuing the convertible note.

Analysis
Using the flowchart below, assess if the issued note is a compound financial instrument in these three steps:

  1. Step 1 is to consider whether there is a contractual obligation to pay cash that the issuer cannot avoid. The answer is yes, as the issuer has to pay an annual cash coupon and could be required to repay the capital amount at the end of three years if the holder chooses not to exercise the conversion option
  2. Step 2 is to consider whether IAS 32 16A – D (regarding puttable instruments) apply. These paragraphs set out a specific and specialist exception from the requirement to classify certain financial instruments, which the issuer has an obligation (or potential obligation) to repurchase, as financial liabilities. This exception does not typically apply to convertible instruments and is not applicable in this example
  3. Step 3 is to consider whether the instrument has any characteristics that are similar to equity. The answer is yes as the instrument contains an option to be converted into equity instruments.

Convertible debt option reserve

Each component of the compound financial instrument needs to be assessed separately. The host debt component will be classified as a financial liability in its entirety. This is because there is an obligation to pay cash that the issuer cannot avoid (see above) and, for this component on a stand-alone basis, there is no feature that is similar to equity.

The conversion feature is then assessed, again on a stand-alone basis. Starting with the box at the top left hand side of the diagram:

  • There is no contractual obligation to pay cash that the issuer cannot avoid. The equity conversion feature can only be settled through the issue of equity shares, otherwise it will simply expire unexercised
  • There is no obligation to issue a variable number of shares. If exercised, the option will result in the issue of 10,000 shares
  • There is no foreign currency element, as the issuer’s functional currency and the currency of the convertible instrument are the same.

Consequently, the conversion feature is classified as an equity component.

This means that the note contains the following liability and equity components:

On initial recognition, the contractual cash flows are discounted at the interest rate that would apply to a note without a conversion feature (12%). This is in order to calculate the fair value of the liability component of the compound financial instrument.

1. Calculation for the fair value of the liability component with a liability and an equity component

Year Cash flow Amount Discounting at 12%

NPV

1 Coupon CU 100 1 / 1.12 = 0.89285

CU 100 x 0.89285 = CU 89

2 Coupon CU 100 1 / 1.12^2 = 0.79719

CU 100 x 0.79719 = CU 80

3 Coupon and principal CU 1,100 1 / 1.12^3 = 0.71178

CU 1,100 x 0.71178 = CU 783

Fair value of the liability component

CU 952

2. The fair value of the convertible debt option reserve

The fair value of the liability component is then deducted from the fair value of the compound financial instrument as a whole, with the balance being taken directly to equity. The residual equity component is the transaction price of CU 1,000 (fair value) less the fair value of the liability component (see calculation) CU 952, i.e. CU 48.

3. Allocation of transaction costs

For compound financial instruments, IAS 32.38 requires these costs to be allocated to the liability and the equity components.

Entity A adjusts the carrying amount of the components for the CU 110 incurred in transaction costs as follows:

Convertible debt option reserve

A Fair value before transaction costs

%

B Transaction costs allocation

A – B = Carrying amount

Liability

CU 952

95%1

CU 105 2

CU 847

Convertible debt option reserve

CU 48

5%3

CU 5 4

CU 43

Convertible debt option reserve

100%

4. Recalculation effective interest rate

The effective interest rate is recalculated after adjusting the carrying amount of the host liability for the transaction costs. This results in the transaction costs being amortised over the term of the convertible note through an adjustment to the effective interest rate, which increases the rate to 17.00%.

Entity A will therefore record interest expense at the effective interest rate (17.00%). The difference between the total interest expense (16.41%) and the cash coupon actually paid (10%) increases the carrying amount of the liability so that, on maturity, the carrying amount is equal to the capital cash repayment that might be required to be made. The following table shows the balance of the liability component over the life of the loan.

Year Opening Interest5 Cash coupon6 Closing
1

CU 847

CU 144

CU (100)

CU 891

2

CU 891

CU 151

CU (100)

CU 942

3

CU 942

CU 158

CU (100)

CU 1,000

Assume that, at the end of Year 3, the holder elects to receive shares. Entity A would derecognise the liability (CU 1,000) and recognises an increase in equity of the same amount; no gain or loss would be recorded on conversion. Conversely, if the holder elects to receive cash, Entity A would simply derecognise the liability CU 1,000 and recognises a corresponding decrease in cash of CU 1,000.

Convertible debt option reserve

The conversion feature of CU 43 is classified in equity – as the convertible debt option reserve, it is not remeasured. Even if the conversion option is not exercised, the amount recorded in equity is not reclassified (or ‘recycled’), through profit or loss, It will be transferred from one equity reserve to another at the end of the option period (whether exercised or not). The only item that affects profit or loss is the recognition of interest expense at the effective interest rate for the liability component.

Deferred taxes

In most jurisdictions, only the coupon cash payment (10% in this example) and transaction costs would be tax deductible and it is unlikely that a tax deduction will be received for the interest expense (16.41% in this example) recorded under additional the effective interest method.

Therefore, a deferred tax arises from the temporary difference between the carrying value of the liability component and the tax base of the liability for tax purposes. If the Entity A is subject to a 30% tax rate and assuming that transaction costs are also deductible over the life of the loan (that is, the element of the interest expense in profit or loss that represents transaction costs is tax deductible rather than the transaction costs being deductible in full when they are incurred), then a deferred tax liability of CU 13 ((CU 900 – CU 857) x 30%) should be recognised on initial recognition with a corresponding entry to equity.

The effect of deferred tax is recognised in equity because IAS 12 Income Taxes requires that the recognition of deferred tax must follow the underlying transaction it relates to, and the temporary difference relates to the amount attributed to the equity conversion option. Convertible debt option reserve

The carrying amounts of the liability component, and the associated tax effects over the life of the note, are summarised below:

Convertible debt option reserve

Initial recognition

Year 1

Year 2

Year 3

Carrying value of the liability

CU 847

CU 891

CU 942

CU 1,000

Tax base of the liability

CU 900

CU 932

CU 965

CU 1,000

Temporary difference

CU 47

CU 41

CU 23

Deferred tax liability (at 30% (effective) tax rate)

CU 14

CU 12

CU 7

Deferred tax expense (income)

CU (2)

CU (5)

CU (7)

Convertible debt option reserve

Convertible debt option reserve option reserve

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