ACCOUNTING FOR COMPOUND FINANCIAL INSTRUMENTS

A compound financial instrument is a financial instrument that has the characteristics of both an equity and liability (debt). An example would be a bond that can be converted into shares. It doesn't matter whether the bondholders will ultimately opt for conversion. As long as there is the option to convert into shares, the financial instrument would carry an equity component. 

IAS 32 Financial Instruments: Presentation requires compound financial instruments to be split into their component parts, i.e.:

• a financial liability (the debt component); and
• an equity instrument (the option to convert into shares).

These must be shown separately in the financial statements.

To illustrate this requirement, let's say Entity A issued a $10 million convertible bond at par. On initial recognition, the bond should be measured at the fair value of consideration received, i.e. $10 million. However, the financial instrument needs to be split into its debt and equity components. The double entry would therefore be:

	Dr	Cash	$10 million
	Cr	Liability - Bond	?
	Cr	Equity	?

Splitting the financial instrument

The financial instrument is split by first determining the debt component. The debt component is calculated as the present value of future cash flows of the instrument discounted using the current interest rate for similar bonds without the conversion rights.

The equity component is then calculated by deducting the debt component from the proceeds of the instrument.

Any transaction costs are then apportioned to the debt and equity components in proportion to the allocation of proceeds.

Illustration 1 (without transaction costs)

On 1 January 20X4, Enzer issued a $50 million three-year convertible bond at par with the following terms:

• There were no issue costs
• The coupon rate is 10%, payable annually in arrears on 31 December
• The bond is redeemable at par on 1 January 20X7
• Bondholders may opt for conversion. The terms of the conversion are two 25 cents shares for every $1 owed to each bondholder on 1 January 20X7
• Bonds issued by similar companies without any conversion rights currently bear interest at 15%

Required:

How should the bond be accounted for by Enzer assuming:

(a) The bondholders opt for conversion

(b) The bondholders opt for cash payment

Solution

This is a compound financial instrument. Enzer is required to present the debt and equity components of the instrument separately in the financial statements.

The debt component is calculated as the present value of future cash flows of the bond discounted using the current interest rate for similar bonds without the conversion rights.

The debt and equity components of the instrument are determined as follows:

Year ended	Cash flow	Discount factor	Present value
		@ 15%
	$000		$000
31 December 20X4	5,000	1/1.15	4,348
31 December 20X5	5,000	1/1.152	3,781
31 December 20X6	55,000	1/1.153	36,163
Debt component			44,292
Proceeds of issue			50,000
Equity component			5,708

Therefore, on initial recognition, Enzer should account for the instrument as follows:

			$000
	Dr	Cash	50,000
	Cr	Liability - Bond	44,292
	Cr	Equity	5,708

Subsequent to initial recognition, the debt component is a normal liability and should be measured at amortised cost as follows:

End of Year	Opening	Effective	Cash	Closing
	balance	interest at 15%	paid	balance
	$000	$000	$000	$000
31 December 20X4	44,292	6,644	(5,000)	45,936
31 December 20X5	45,936	6,890	(5,000)	47,826
31 December 20X6	47,826	7,174	(5,000)	50,000

The carrying amounts at 1 January 20X7 are:

	$000
Equity	5,708
Liability - Bond	50,000
	55,708

On conversion

Number of shares issued ($50 million x 2 shares) = 100 million shares.

The value of shares issued is 100 million shares x 25c = $25 million.

The remaining $30,708,000 should be classified as share premium.

The following entries should be made:

			$000
	Dr	Equity	5,708
	Dr	Liability - Bond	50,000
	Cr	Share capital	25,000
	Cr	Share premium	30,708

Note: Both the equity and liability components are extinguished by the issue of shares.

On redemption

The liability of $50 million will be extinguished by cash payment. The equity component will remain within equity, as a non-distributable reserve.

The following entries should be made:

			$000
	Dr	Liability - Loan	50,000
	Cr	Cash	50,000

Illustration 2 (without transaction costs) 

On 1 January 20X4, Enzer issued a $50 million three-year convertible bond at par with the following terms:

• Issue costs amounted to $500,000
• The coupon rate is 10%, payable annually in arrears on 31 December
• The bond is redeemable at par on 1 January 20X7
• Bondholders may opt for conversion. The terms of the conversion are two 25 cents shares for every $1 owed to each bondholder on 1 January 20X7
• Bonds issued by similar companies without any conversion rights currently bear interest at 15%
• The impact of the issue costs is to increase the effective interest rate to 15.425%

Required:

How should the bond be accounted for by Enzer assuming:

(a) The bondholders opt for conversion

(b) The bondholders opt for cash payment

Solution

Enzer is required to present the debt and equity components of the instrument separately in the financial statements.

The debt component is calculated as the present value of future cash flows of the bond discounted using the current interest rate for similar bonds without the conversion rights.

The debt and equity components of the instrument are determined as follows:

Year ended	Cash flow	Discount factor	Present value
		@ 15%
	$000		$000
31 December 20X4	5,000	1/1.15	4,348
31 December 20X5	5,000	1/1.152	3,781
31 December 20X6	55,000	1/1.153	36,163
Debt component			44,292
Proceeds of issue			50,000
Equity component			5,708

The issue costs would be allocated to the debt and equity components in proportion to the allocation of proceeds.

	Debt		Equity		Total
	$000		$000		$000
Proceeds	44,292		5,708		50,000
Issue costs	(443)		(57)		(500)
	43,849		5,651		49,500

Therefore, on initial recognition, Enzer should account for the instrument as follows:

			$000
	Dr	Cash	50,000
	Cr	Liability - Bond	44,292
	Cr	Equity	5,708

			$000
	Dr	Liability - Bond	443
	Dr	Equity	57
	Cr	Cash	500

Subsequent to initial recognition, the debt component is a normal liability and should be measured at amortised cost as follows:

End of Year	Opening	Effective	Cash	Closing
	balance	interest at 15.425%	paid	balance
	$000	$000	$000	$000
31 December 20X4	43,849	6,764	(5,000)	45,613
31 December 20X5	45,613	7,036	(5,000)	47,649
31 December 20X6	47,649	7,351	(5,000)	50,000

The carrying amounts at 1 January 20X7 are:

	$000
Equity	5,651
Liability - Bond	50,000
	55,651

On conversion

Number of shares issued ($50 million x 2 shares) = 100 million shares.

The value of shares issued is 100 million shares x 25c = $25 million.

The remaining $30,651,000 should be classified as share premium.

The following entries should be made:

			$000
	Dr	Equity	5,651
	Dr	Liability - Bond	50,000
	Cr	Share capital	25,000
	Cr	Share premium	30,651

Note: Both the equity and liability components are extinguished by the issue of shares.

On redemption

The liability of $50 million will be extinguished by cash payment. The equity component will remain within equity, as a non-distributable reserve.

The following entries should be made:

			$000
	Dr	Liability - Loan	50,000
	Cr	Cash	50,000

Important points to note:
Note that if the bondholders opt for conversion, both liability and equity will be extinguished as the equity component will be converted into shares. However, if the bondholders opt for cash redemption, then only the liability component will be extinguished because there are no shares being issued, hence the equity component will not be converted. In this case, the equity component will remain as a non-distributable reserve, i.e. it cannot be used as a reserve from which dividends are paid.