1 Best Convertible note with embedded derivative

Convertible note with embedded derivative

provides an introduction to this accounting subject, completed in the calculation example provided here. In practice, many conversion features in convertible notes fail equity classification, which means that the conversion feature is a financial liability.

The reason that many conversion features fail equity classification is that they contain contractual terms that result in the holder of the conversion feature having rights that are different to those of existing shareholders. This is because the contractual terms mean that either:Convertible note with embedded derivative Basics

  • The number of shares to be issued varies
  • The amount of cash (or carrying amount of the liability) converted into shares varies
  • Both the number of shares and the amount of cash (the carrying amount of the liability) vary.

The commercial effect of this is that the holder of the conversion feature obtains a different return in comparison with an investor that holds equity shares.

Conversion features that fail equity classification are derivatives because they are either written options (that is, options that provide the holder with a choice over whether the convertible note is exchanged for shares or cash) or forward contracts under which an entity will issue shares in order to extinguish an obligation, with no cash settlement alternative.

This links to the definition of a derivative in IFRS 9, with all three of the characteristics of a derivative being met. These characteristics are:

  • The value of the conversion feature changes in response to the share price of the issuer
  • The investment required to purchase the option (which is the present value of the reduction in interest rate that is paid on the convertible note in comparison with an loan note with no conversion feature) is less than would be required to purchase the equivalent number of shares (the comparison that is made is to compare the cost of acquiring the conversion feature with the cost of acquiring other instruments that would have a similar response to future changes in the fair value of the issuer’s shares – which would be an investment in the shares themselves)
  • The conversion feature is settled at a future date.Convertible note with embedded derivative Basics

Conversion features that fail equity classification and are accounted for as derivative liabilities are typically accounted for separately from the host instruments. This is because the fair value of the conversion feature is affected by changes in the fair value of the issuer’s shares, and the fair value of the host loan is not. This means that the conversion feature (an embedded derivative) is not what IFRS 9 refers to as being ‘closely related’ to the host contract. Convertible note with embedded derivative Basics

The effect of this is that for many convertible notes, a host loan will be accounted for at amortised cost, with an embedded derivative liability being measured at fair value with changes in value being recorded in profit or loss. Convertible note with embedded derivative Basics

The terms of some convertible notes which contain conversion features that are required to be accounted for as derivative liabilities can mean that the accounting for each of the separate components can become complex. One approach which can simplify the accounting is to use the IFRS 9 ‘fair value option’.

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Under this approach, a contract that contains one or more embedded derivatives that would normally be required to be accounted for separately can instead be accounted for in its entirety at fair value through profit or loss. Although this may appear to be an attractive option, it can give rise to additional volatility in amounts reported in profit or loss. This is because not only the embedded derivative(s), but also the host loan, will be measured at fair value with this being affected by factors which include changes in interest rates, and changes in the issuer’s own credit rating (because this affects the rate of interest that the issuer would have to pay for new borrowings).

The remainder (and the numbers) illustrates the accounting approach to be followed where the IFRS 9 ‘fair value option’ is not used. This means that the host contract will be accounted for at amortised cost. Convertible note with embedded derivative Basics

The accounting for a convertible note with an embedded derivative liability is set out in IFRS 9. The embedded derivative liability is calculated first and the residual value is assigned to the debt host liability component (IFRS 9 B3.2.4). This is in contrast to where a convertible note is a compound instrument with an equity component, where the fair value of the liability component is calculated first with the equity being residual.

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Determining the fair value components of a convertible note with a liability and an embedded derivative component:

Convertible note with embedded derivative Basics

Example Convertible note with embedded derivative

Entity B issues a note with a 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 at the end of three years, the holder has an option either to receive a cash repayment of CU 1,000 or to convert the note into the Entity B’s shares. The note would be converted into Entity B’s shares using the average of the lowest five days value weighted average price (VWAP) in the previous 30 days prior to maturity. The conversion feature is determined to have a fair value of CU 20 at issue date.

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

Analysis Convertible note with embedded derivative

Convertible notes - Basic requirements Convertible notes - Basic requirements

Using the flowchart above for the entire instrument, it is assessed as being a financial liability with an embedded derivative liability. The analysis is as follows:

  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 (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. The question of whether the conversion feature meets the criteria to be classified as equity is dealt with separately.

For the purposes of the compound instrument, 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
  • However, there is an obligation to issue a variable number of shares – the number of shares to be issued is based on the lowest 5 day VWAP in the last 30 days prior to maturity.

Consequently, the conversion feature is also classified as liability.

This means that the note contains the following components:

  • Contractual cash flows of 10% annual coupons and a cash repayment of CU 1,000 (liability)
  • The conversion feature to convert the liability to in to equity of the issuer at the lowest five day share price in the previous 30 days prior to maturity (an embedded derivative liability).

For convertible notes with embedded derivative liabilities, the embedded derivative liability is determined first and the residual value is assigned to the debt host liability. Therefore, the debt host liability is initially recognised at CU 980 being the residual value from deducting the fair value of the derivative liability from the transaction price (i.e. CU 1,000 less CU 20).

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Transaction costs Convertible note with embedded derivative

Transaction costs are to be apportioned to the debt liability and the embedded derivative. The portion attributed the conversion feature is immediately expensed, because the embedded derivative liability is accounted for at fair value through profit or loss. For the portion of transaction costs that are attributed to the loan, these are added to the carrying amount of the financial liability and amortised as part of the effective interest rate.

Entity B adjusts the carrying amount of the liability component for transaction costs incurred as follows:

Allocation of transaction costs Convertible note with embedded derivative

A Fair value before transaction costs

%

B Transaction costs allocation

A – B = Carrying amount

Liability

CU 980

98%1

CU 98 2

CU 882

Derivative liability

CU 20

2%3

CU 2 4 > to profit or loss

CU 205

100%

The effective interest rate is recalculated after adjusting for the transaction costs, and for the host liability component it is 15.18 % (this is determined by establishing the rate that is required to discount the contractual cash flows back to the carrying amount, as adjusted for transaction costs). Entity B will therefore record interest expense at the effective interest rate (15.18%). The difference between interest expense (15.18%) and the cash coupon (10%) increases the carrying amount of the liability so that, on maturity, the carrying amount is equal to the cash payment that might be required to be made.

The following table shows the balance of liability component over the life of the loan.

Year

Opening

Interest6

Cash coupon7

Closing

1

CU 882

CU 134

CU (100)

CU 916

2

CU 916

CU 139

CU (100)

CU 955

3

CU 955

CU 145

CU (100)

CU 1,000

Derivative liability

The fair value of the conversion feature would have to be determined at each reporting date and the fair value changes would be recognised in profit or loss. The following table sets out the effect on profit or loss assuming the following fair values at each year end:

Year

Fair value of conversion feature

Profit or (loss) effect

CU (20) 8

1

CU (100)

CU (80)

2

CU 0

CU 100

3

CU (300)

CU (300)

Thus, if the conversion feature is classified as a derivative liability, this will often lead to a significantly higher and more volatile expense pattern in trading profit or loss. This is because a derivative liability is remeasured to fair value at each reporting date, whereas if the conversion feature is classified as equity, because if equity classification is met, no re-measurement of the conversion feature is required.

See also: IFRS Community – Convertible note

Convertible note with embedded derivative

Convertible note with embedded derivative The numbers

 

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