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Compound Financial Instrument

The document discusses the accounting requirements for compound financial instruments under IAS 32. A compound financial instrument has characteristics of both a financial liability and equity. It must be split into its components and shown separately on the statement of financial position. The document provides an example of accounting for a convertible bond, calculating the debt component using present value of cash flows and equity component as the residual. It discusses the initial recognition and subsequent measurement of the components.

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206 views1 page

Compound Financial Instrument

The document discusses the accounting requirements for compound financial instruments under IAS 32. A compound financial instrument has characteristics of both a financial liability and equity. It must be split into its components and shown separately on the statement of financial position. The document provides an example of accounting for a convertible bond, calculating the debt component using present value of cash flows and equity component as the residual. It discusses the initial recognition and subsequent measurement of the components.

Uploaded by

Marissa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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FWD PH

30 June 2011

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 Present


factor 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 paid balance
15%
$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 Present


factor 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 paid balance
15.425%
$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.

Admin at Thursday, June 30, 2011

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