Compound Financial Instrument

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Week Week 7

A compound financial instrument is a financial instrument that has the

characteristics of both an equity and liability (debt)
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).

Allocate separately

Common example: Bonds payable on conversion option

Characteristics of a Financial Instrument

a. There must be a contract
b. There are atleast two parties to the contract
c. The contract shall give rise to a financial asset of one party and financial liability
or equity instrument of another party

Share Warrants
an instrument giving the holder the right to purchase the issuer's share at a
specified price during a definite period

Conversion Options

Compound Financial Instrument 1

 an instrument giving the holder the right to convert the holder's right to
receive the issuer's specified no. of shares instead of collecting the principal
of the bonds

shares yung ipang-babayad ni company sa utang niya

Compound Instrument

Allocation of Issue Price

Unang kukunin ang value ni bonds in intial measurement

Method 1

Fair value of bonds without SW or Co

Method 2

Compound Financial Instrument 2

 PV of Principal) + PV of Nominal Interest)
Total selling price Bonds + SW/CO xx

Less: Selling price of bonds xx

Selling Price of SW/CO (residual) xx

Illustration:
Share Warrants - Separation & Exercise of Warrants

On January 1, 2016, Dragonflame Company issued P5,000,000 of 12%

nonconvertible bonds at 110 which are due on December 31,2020. In addition,
each P1,000 bond was issued with 30 detachable share warrants, each of which
entitled the bondholder to purchase for P50 one shares of Dragonflame Compay
with par value of P25

On January 1, 2016, the quoted market valye of each warrant was P5. The market
value of the bond ex-warrant at the time of issuance is 98.

 What is the carrying amount of the bonds payable at the time of issuance?

 What amount of the proceeds from the bond issue should be recognized as an
increase in shareholders' equity? 4,350,000

 What amount should be recorded as share premium upon exercise of all of the
share warrants? 4,350,000

Solution:

 Selling Price = 5,500,000 5,000,000 x 110%

Bonds = 4,900,000 5M x 98%

Total Selling Price 5,500,000

Less: Selling price of Bonds 4,900,000

Compound Financial Instrument 3

 Selling price of SW/CO 600,000

Ans. 4,900,0000
Initial measure P4,900,000

Less: Face amount 5,000,000

Premium (discount) P100,000

Journal Entry:

Dr. Cash 5,500,000

Dr. Discount 100,000

Cr. Bonds Payable 5,000,000

Cr. Share premium - SW 600,000

2. 600,000

FS Preparation Stage

B.S. I.S.
Initial Measure Initial Measure xx
xx Effective rate x%
1 + Effective Interest Expense xx
x%

Nominal Interest
(xx)

Amortize Cost
xx

Share Premium xx

Compound Financial Instrument 4

 Exercise of Share Warrants
Step By Step Procedure)

 Compute total consideration received Cash @ exercise price) + Share

warrants

 Compute the consideration given-up (ordinary shares = par value sold)

 Compute the gain on exercise (but there is no gain, instead share premium)

 Compute the total consideration received

Exercise price xx

Times: No. of shares purchases xx

Cash proceeds xx

Add: Value of SW returned (residual) xx

Total consideration received xx

Less: Par value of shares given up (par per share * exercise) (xx)
Gain or Loss xx

Illustration:

Share Warrants - Separation & Exercise of Warrants

On January 1, 2016, Dragonflame Company issued P5,000,000 of 12%

nonconvertible bonds at 110 which are due on December 31,2020. In addition,
each P1,000 bond was issued with 30 detachable share warrants, each of which
entitled the bondholder to purchase for P50 one shares of Dragonflame Compay
with par value of P25

Compound Financial Instrument 5

 On January 1, 2016, the quoted market valye of each warrant was P5. The market
value of the bond ex-warrant at the time of issuance is 98.

 What is the carrying amount of the bonds payable at the time of issuance?

 What amount of the proceeds from the bond issue should be recognized as an
increase in shareholders' equity? 4,350,000

 What amount should be recorded as share premium upon exercise of all of the
share warrants? 4,350,000

Exercise price P50

Times: No. of shares purche 150,000 5k x 30

Cash proceeds 7,500,000

Add: Value of SW returned 600,000

Total consideration received 8,100,000

Less: Par value of shares given up 3,750,000 ← 25 x 150,000

Gain SPExcess) P4,350,000

Journal Entry:

Dr. Cash 7,500,000

Dr. Share Premium - SW 600,000

Cr. Share Capital 3,750,000

Cr. Share Premium - Excess 4,350,000

If net increase yung tinatanong, minues yung SPExcess sa Share premium

Accounting for the Bonds Separately

Compound Financial Instrument 6

 On January 1, 2021, Jumbo Corporation issued a P3,000,000 6% convertible
bonds at par. The bonds are redeemable at a premium of 10% on December 31,
2024 or it may be converted into ordinary shares on the basis of 50 shares for
each P1,000 bond at the option of the holder.

The interest rate for an equivalent bond without the conversion rights would have
been 10%.

Present value of 1 at 10% for 4 periods

0.6830

Present value of ordinary annuity of 1 at 10% for 3 periods

3.1699

 The issuance of convertible bonds on January 1, 2021 increased the entity's

equity by

 The carrying amount of the bonds payable as of December 31, 2021 is

Solution:
Total Selling Price Bonds + CO xx

Less: Selling Price of Bonds (xx)

Selling Price of SW/CO Residual) xx

Method 2
Amount PV Factor PV
Amount

Principal 3,000,000 0.6830

P2,049,000
Nominal Int. 180,000 3.1699
570,582
PV of CF P2,619,582

Compound Financial Instrument 7

 Total Selling Price Bonds + CO P3,000,000

Less: Selling Price of Bonds 2,619,582

Selling Price of SW/CO Residual) P380,418

Balance Sheet
Initial Measure 2,619,582

1 + Effective 1.10
Nominal Interest 180,000
Amortize cost 2,701,540

Conversion Options - Separation & Exercise of Warrants

On January 1, 2019, Dias Company issued 3-year, 4,000 convertible bonds at face
value of P1,000 per bond. Interest is to be paid annually in arrears at the stated
coupon rate of 6%. Each bond is convertible, at the holder's option, into 200 P2
par value ordinary shares at any time up to maturity.

On the date of issuance, the prevailing market interest rate for similar debt without
the conversion privilege was 9%.

On the same date, the market price of one ordinary share was P3. The bonds were
converted on December 31, 2020.
Present value of 1 at 9% for 3 periods 0.7722

Present value of ordinary annuity of 1 at 9% for 3 periods 2.5313

 The equity component of the convertible debt is 303, 688

 The interest expense to be reported on Dias Company's income statement for

the year ended December 31, 2020 is 341,008

 Entry to record the bond conversion on December 31, 2020, should include a
credit to share premium - issuance of P2,593,676

Compound Financial Instrument 8

 Face value = 4,000,000
Nominal rate = 6%

Solution:
Method 2

Amount PV Factor PV
Amount
Principal 4,000,000 0.7722
P3,088,800
Nominal Int. 240,000 2.5313
607,512

PV of CF P3,696,312
Total Selling Price Bonds + CO P4,000,000

Less: Selling Price of Bonds 3,696,312

Selling Price of SW/CO Residual) P303,688
Initial Measure P3,696,312

Times: Effective interest rate 9%

Interest Expense, 2019 P332,668

For the following years:

CA beg 1/1/19 P3,696,312

Times: 1 + Effective Interest Rate 1.09

Less: Nominal Interest 240,000
CA 1/1/20 3,788,980

Times: Effective Interest Rate 9%

Interest Expense, 2020 P341,008

Initial Measurement 3,696,312

Compound Financial Instrument 9

 Times: Effective Interest rate 1.09
Less: Nominal interest 240,000

Times: Effective interest rate 1.09

Less: Nominal interest 240,000
Carrying amount - 12/31/20 P3,889,988

Add: Value of conversion option used 303,688

Total consideration received P4,193,676

Less: Par value of shares given uo

4,000 x 200 x 2 1,600,000

Gain SP - Excess) P2,593,676

Compound Financial Instrument 10