FINANCIAL LIABILITIES

MODULE 3:
COMPOUND FINANCIAL INSTRUMENTS (Bonds with warrants &
Convertible bonds)
DEBT RESTUCTURING
 COMPOUND FINANCIAL INSTRUMENTS

• A financial instrument that has the characteristics of both a liability and an equity..
• In accounting for compound financial instruments, IFRS requires that compound financial instruments be
accounted and presented separately according to their substance based on the definitions of liability and
equity.
• The split/ bifurcation is made at the issuance of the compound financial instrument and not revised for
subsequent changes in market interest rates, share prices or other event that changes the likelihood that the
conversion option will be exercised.
 BONDS WITH WARRANTS

• When bonds are issued with share warrants, the bondholders are given the right to acquire a specified number
of shares of the issuing corporation at a given price within a certain period of time.
• The investor has acquired a dual set of rights : a.) right to receive interest and principal payment on bonds
b.) right to acquire ordinary shares
• A bond with warrants can either be detachable or non-detachable. When warrants are detachable, it
means that the warrants are allowed to be sold separately from the bond while when it is non- detachable, it
is the opposite wherein the warrants are not allowed to be sold separately from the bond.
• When warrants are included in the issue of the bond, the issue price is bifurcated first to the bonds
based on its market value and any remainder is related to the warrants. The amount related to the
warrants is credited to Share Warrants Outstanding account and presented as part of
additional paid in capital in the equity section of statement of financial position.
• When share warrants are subsequently exercised, the ordinary shares are purchased at the option
price and share warrants outstanding is derecognized
 ILLUSTRATIVE PROBLEM :
ISSUE PRICE WITHOUT WARRANTS IS
DETERMINABLE
On January 1, 2019, ACT Company issued 1,000 of its 12%, 5-year, P 5,000 face value bonds with non-detachable share
warrants at 110. Each P 5,000 bond has a non-detachable warrant that is entitled to purchase one share of ACT
Company’s P 100 par ordinary for P 125. The following market values were available after issuance : Bonds without
warrants sells at 105 and Ordinary share – P 135.
Bifurcation: Allocated to bonds
Issue price – (5,000,000 x 110%) P 5,500,000 ( 5,000,000 x 105%) = 5,250,000

1. The entry to record the issuance:

Allocated to warrants

Cash 5,500,000 (5,500,000 – 5,250,000) = 250,000

Bonds payable 5,000,000 2.) If share warrants are exercised subsequently,
Premium on Bonds payable 250,000 the entry is:
Share Warrants Outstanding 250,000
Cash 125,000
Share warrants outstanding 250,000
Ordinary Share Capital 100,000
Share Premium- Ordinary 275,000
 ILLUSTRATIVE PROBLEM :
ISSUE PRICE WITHOUT WARRANTS IS NOT
READILY DETERMINABLE
On January 1, 2019, ACT Company issued 1,000 of its 12%, 5-year, P 5,000 face value bonds with non-detachable share
warrants at 110. Each P 5,000 bond has a non-detachable warrant that is entitled to purchase one share of ACT
Company’s P 100 par ordinary for P 125. The market value of the ordinary share on the date of issuance was P
130.The bond without the warrants attached could be sold to yield 10% at the time of issuance. Interest is payable
annually.
Bifurcation: Allocated to bonds
Present value of principal:
P 5,000,000 X 0.6209… = 3,104,606.62
Issue price – (5,000,000 x 110%) P 5,500,000 Present value of interest:
P 600,000 X 3.7907… = 2,274,472.06
Total present value. 5,379,078.68
1. The entry to record the issuance:
Allocated to warrants
( 5,500,000 - 5,379,078.68) = 120,921.32
Cash 5,500,000
Bonds payable 5,000,000 2.) If share warrants are exercised subsequently,
Premium on Bonds payable 379,079.68 the entry is:
Share Warrants Outstanding 120,921.32
Cash 125,000
Share warrants outstanding 120,921.32
Ordinary Share Capital 100,000
 CONVERTIBLE BONDS

• Convertible bonds give the holder thereof the right to convert their holdings into ordinary shares or other
securities of the issuing corporation within a specified period of time.
• The proceeds from the issuance of convertible bonds is comprised of two components:
a.) a financial liability ( bonds) and
b.) an equity instrument (bond conversion privilege)
• The issue price is also bifurcated under the residual approach, wherein the issuer of a convertible bond
determines first the amount of liability by measuring the fair value of a similar liability that does not have an
associated equity component and any excess from the issue price is recognized as the equity component.
• Same with bonds with warrants, if the quoted price is not readily determinable, the amount allocated to the
financial liability component is equivalent to the present value of future cashflows discounted at the market rate
of interest for similar instruments.
 CONVERTIBLE BONDS

• Upon conversion of bonds payable into ordinary shares, the carrying value of the debt converted is the value
assigned to the ordinary shares issued in exchange. Hence, no gain or loss is recognized upon conversion.
Paid in capital arising from bond conversion privilege relating to the bonds converted is cancelled from the
accounts.
• Any accrued interest at the time of conversion of bonds is paid in cash and recorded as interest
expense.
• Expenditures incurred related to the conversion are charged to the additional paid in capital
related to shares issued upon conversion. Any excess of the expenditures over the additional paid in
capital related to shares issued upon conversion shall be recorded as expense during the period of conversion.
• When convertible bonds are retired prior to maturity, the retirement price is allocated to the debt and
liability settled and equity portion for bond conversion privilege. After allocation of the consideration, there is a
gain or loss recognized in the profit or loss related to the liability component. Any excess of the equity
cancelled as a result of the retirement over the consideration allocated to equity component is taken to equity.
 ILLUSTRATIVE PROBLEM:

On January 1, 2019, ACT Company issued 1,000 of its 12%, 5-year, P 5,000 face value convertible bonds at 110. Each P
5,000 bond is convertible into 10 shares of P 100 par value ordinary shares on the date of maturity. Without the
conversion feature, the bonds can be sold at 105.

Bifurcation: Allocated to bonds

Issue price – (5,000,000 x 110%) P 5,500,000 ( 5,000,000 x 105%) = 5,250,000

1. The entry to record the issuance:

Allocated to equity (bond conversion privilege)
Cash 5,500,000 (5,500,000 – 5,250,000) = 250,000
Bonds payable 5,000,000
Premium on Bonds payable 250,000 2.) If bonds are exercised, the entry to record:
Bond conversion Privilege 250,000
Cash 125,000
Share warrants outstanding 250,000
Ordinary Share Capital 100,000
Share premium- Ordinary 275,000
 WHAT IF BEFORE MATURITY DATE, BOND
CONVERSION PRIVILEGE IS EXERCISED?

1. All bonds are converted.

Using the same problem from the previous slide and assuming on the date of conversion, the balance of the premium
on bonds payable is P 150,000 and each ordinary share sells for P 135.

The entry to record the conversion is:

Because each P 5,000 bond is convertible to
10 shares, and all the 1,000 of P 5,000 bond is
Bonds payable 5,000,000 converted to ordinary shares, it will be equivalent to:
Premium on bonds payable 150,000
Share premium-Bond conversion Privilege 250,000 1,000 x 10 shares = 10,000 shares
Ordinary Share Capital 1,000,000
Share premium- Ordinary 4,400,000
 WHAT IF BEFORE MATURITY DATE, BOND
CONVERSION PRIVILEGE IS EXERCISED?

1. Partial bonds are converted.

Using the same problem and assuming holder of P 3,000,000 face value bonds exercised their conversion when the
balance of the premium on bonds payable is P 150,000 and each ordinary share sells for P 135.

The entry to record the conversion is:

Because each P 5,000 bond is convertible to
10 shares, and only 600 out of 1,000 of P 5,000
bond is converted to ordinary shares, it will be
equivalent to:
Bonds payable 3,000,000
Premium on bonds payable 90,000 600 x 10 shares = 6,000 shares
Share Premium- Bond conversion Privilege. 150,000
Ordinary Share Capital 600,000
Share premium- Ordinary 2,640,000
WHAT IF THERE ARE EXPENDITURES
INCURRED RELATED TO THE CONVERSION?

Using the same problem and assuming holder of P 3,000,000 face value bonds exercised their conversion when the
balance of the premium on bonds payable is P 150,000 and each ordinary share sells for P 135. Expenditures paid
related to the conversion was P 10,000.

The entry to record the conversion is:

Bonds payable 3,000,000

Premium on bonds payable 90,000
Share Premium - Bond conversion Privilege 150,000
Ordinary Share Capital 600,000
Share premium- Ordinary 2,640,000

Share premium – Ordinary 10,000

Cash 10,000
 WHAT IF THE BONDS ARE RETIRED BEFORE
MATURITY?

Assuming on the date of retirement, the balance of the premium on bonds payable is P 150,000 and interest payment and
premium amortization have been recorded properly. The P 5,000,000 bonds were retired at 103, and without the conversion
privilege, these bonds would have been sold at this date at 101. The balance of bond conversion privilege on this date is P
250,000.
Bifurcation: Allocated to bonds
Retirement price – (5,000,000 x 103%) P 5,150,000 ( 5,000,000 x 101%) = 5,050,000

Allocated to equity
(5,150,000 – 5,050,000) = 100,000
Gain or loss on retirement :
Retirement price allocated to bonds VS. Carrying value of bonds retired
Bonds payable – 5,000,000
Premium on bonds payable- 150,000
5,050,000 5,150,000

GAIN ON RETIREMENT OF BONDS = 100,000

WHAT IF THE BONDS ARE RETIRED BEFORE
MATURITY?

Excess of equity cancelled :

Retirement price allocated to equity VS. Carrying value of equity cancelled

100,000 250,000

SHARE PREMIUM-
UNEXERCISED CONVERSION PRIVILEGE = 100,000
 TROUBLED DEBT RESTRUCTURING

• In periods of downward economic conditions, the creditor may grant concession to the debtor that it would not
otherwise grant under normal conditions.
• This may take the form:
a.) Asset swap
- non-cash assets are used to settle the obligation
- A gain on restructuring is recognized by the debtor equal to excess of the carrying amount of the debt over the fair
value of the asset transferred. Meanwhile, a gain or loss on disposal of the asset is recognized equal to asset’s fair value
and carrying amount.

CARRYING VALUE OF DEBT > FAIR VALUE OF THE ASSET > OR < CARRYING VALUE OF ASSET
I_______________________________I I___________________________________I
Gain on debt restructuring Gain or loss on exchange of asset
I______________________________+_________________________I
taken to profit or loss
 TROUBLED DEBT RESTRUCTURING

b.) Equity swap

- Debtor issues its own shares to settle its obligation.
- Based on IFRIC 19 Extinguishing Financial Liabilities with Equity Instruments, the equity instruments issued in settlement of
the debt obligation in a troubled debt restructuring shall be measured at their FAIR VALUE.
- In cases where the fair value of the equity instruments cannot be reliably measured, the fair value of the financial
liability settled shall be used.
- Any difference of the carrying value of the debt and the fair value of the equity or financial liability which is
determinable is taken to profit or loss.
c.) Modification of Debt terms
- Modification of debt terms may come in various forms :
1. Reduction of interest rate
2. Reduction or condonation of accrued interest
3. Reduction of principal amount
4. Extension of maturity date
5. Moratorium on the payment of interest/ principal
 TROUBLED DEBT RESTRUCTURING

c.) Modification of Debt terms

- Modification of debt terms may come in various forms :
1. Reduction of interest rate
2. Reduction or condonation of accrued interest
3. Reduction of principal amount
4. Extension of maturity date
5. Moratorium on the payment of interest/ principal

• Derecognition of a financial liability through modification of debt is covered under IFRS 9, which states that an
exchange between an existing borrower and lender of debt instruments with substantially different terms shall
be accounted for as extinguishment of original financial liability and recognition of a new financial liability.
• The terms is said to be substantially different if the discounted present value of cashflows under the new terms using
the original effective rate is at least 10% different from the discounted present value of the remaining cashflows of the
original financial liability.Thus,
If the difference of CARRYING VALUE OF DEBT over PRESENT VALUE OF NET CASHFLOW UNDER NEW TERMS
USING THE ORIGINAL EFFECTIVE INTEREST RATE OF ORIGINAL OBLIGATION ≥ 10% OF CARRYING VALUE OF
DEBT  Substantial and qualifies for derecognition of original financial obligation and recognition of new financial liability.
 ILLUSTRATIVE PROBLEM: ASSET SWAP
On January 1,2017, ACT company borrowed funds from DEF Finance by issuing a promissory note for P 1,000,000. Due to the
economic downtrend in the industry of ACT Company, the company experienced low sales and therefore cannot meet its
obligation. On December 31, 2019,which is the maturity date of the obligation, DEF finance accepted the offer of ACT
Company’s building with a cost of P 1,500,000 and accumulated depreciation balance on this date of P 150,000 in full
settlement of its P 1,000,000 principal and annual accrued interest at 10%. Interest is payable annually and the building has a fair
value on the date of restructuring of P 800,000.
CARRYING VALUE OF DEBT > FAIR VALUE OF THE ASSET > OR < CARRYING VALUE OF ASSET
Notes Payable – P 1,000,000
Interest payable - 100,000
1,100,000 800,000 1,350,000

I______________________I I_______________________________I
Gain on debt restructuring Loss on exchange of asset
300,000 550,000
I________________+_________________________I
850,000
 ILLUSTRATIVE PROBLEM: ASSET SWAP

ACT Company will record the restructuring of the notes as follows:

Notes payable 1,000,000

Interest payable 100,000
Loss on exchange of building 550,000
Accumulated Depreciation- Building 150,000
Building 1,500,000
Gain on Debt Restructuring 300,000
 ILLUSTRATIVE PROBLEM: EQUITY SWAP
Using the same problem, assuming DEF Finance agreed to receive 50,000 ordinary shares of ACT Company in full settlement of its
obligation. ACT Company’s ordinary share has a par value of P 10 and a fair value of P 20.
CARRYING VALUE OF DEBT VS. FAIR VALUE OF THE ASSET
Notes Payable – P 1,000,000
Interest payable - 100,000 ( 50,000 shares X P 20)
1,100,000 1,000,000

I___________________________________________I
GAIN OF DEBT RESTRUCTURING = 100,000

The entry to record the debt restructuring:

Notes payable 1,000,000
Interest payable 100,000
Gain on debt restructuring 100,000
Ordinary share premium 500,000
Share premium- Ordinary 500,000
 ILLUSTRATIVE PROBLEM: MODIFICATION OF DEBT TERMS
Using the same problem, assuming DEF Finance agreed to the following modifications on December 31, 2019:
a.) Extension of maturity date to December 31,2022. b.) Reduction of interest rate from 10% to 8%.
c.) Condonation of accrued interest d.) Reduction of principal to P 800,000.

To know whether the modification of the terms is substantially different from the original obligation:
CARRYING VALUE OF THE DEBT VS PRESENT VALUE OF FUTURE CASHFLOWS
UNDER NEW TERMS
Present value of the principal:
Notes payable – P 1,000,000 P 800,000 X 0.7513…= 601,051.84
Interest payable – 100,000 Present value of interests:
1,100,000 P 64,000 X 2.4868…. = 159,158.53
Total Present value = 760,210.27
I______________________________________________________________________I
DIFFERENCE= 1,100,000 – 760, 210.27 = 339,789.63
IS IT ≥ 10% OF CV = 339,789.63/ 1,100,000 = 30.89%
Because the difference is greater than ≥ 10% of carrying value of debt, the terms is significantly different and it
qualifies for derecognition of old financial obligation and creation of new financial liability. Gain on debt
restructuring is recognized and taken to profit or loss.
 ILLUSTRATIVE PROBLEM: MODIFICATION OF DEBT TERMS

ACT Company will record the restructuring of the notes as follows:

Notes payable 1,000,000

Interest payable 100,000
Discount of Restructured Notes payable 39,789.73
Restructured Notes payable 800,000
Gain on Debt Restructuring 339,789.63