are that shares are issued on 1 January 2017, but subscribers to the IPO are required to pay only €3 per share on
1 January 2017 followed by two further instalments of €1 per share on 1 January 2018 and 1 January 2019.
Example 43.3: Right to call for additional equity capital
A start-up technology entity with a functional currency of UK pounds sterling is unsure of its working capital
requirements for the first few years of its operations. It therefore enters into an agreement with its major
shareholders whereby it can require those shareholders to contribute an additional £2 per share at any time
during the next seven years.
One view might be that the situation in Example 43.2 is not a contract for the future
issue of equity – the share has already been issued, and so it would be quite appropriate
to record a receivable for the deferred subscription payments. The accounting standard
IFRS for Small and Medium-Sized Entities indicates that a receivable should be
recognised only for shares that have been issued, but that such a receivable should be
recognised as a deduction from equity, not as an asset.22 The standard states that this
proposal is derived from IAS 3223 – an assertion difficult to reconcile with the discussion
above. Interestingly, an early IASB staff draft of the exposure draft of IFRS for Small and
Medium-Sized Entities (as made available on the IASB’s website as at September 2006)
admitted, with perhaps unintended candour, that this treatment is ‘not in any
standard’!24 In our view, current IFRS requires any receivable recognised in respect of
an issued share to be shown as an asset.
Financial instruments: Financial liabilities and equity 3541
On the other hand, it is clear from IAS 32 that no receivable would be recognised if the
arrangement provided for the entity actually to issue further shares (pro rata to the
shares initially issued) for €1 on 1 January 2018 and 1 January 2019.
6 COMPOUND
FINANCIAL
INSTRUMENTS
6.1 Background
While many financial instruments are either a liability or equity in their entirety, that is
not true for all financial instruments issued by an entity. Some, referred to as compound
instruments in IAS 32, contain both elements. A compound financial instrument is a
non-derivative financial instrument that, from the issuer’s perspective, contains both a
liability and an equity component. [IAS 32.28, AG30]. Examples include:
• A bond, in the same currency as the functional currency of the issuing entity,
convertible into a fixed number of equity instruments, which effectively comprises:
• a financial liability (the issuer’s obligation to pay interest and, potentially, to
redeem the bond in cash); and
• an equity instrument (the holder’s right to call for shares of the issuer).
IAS 32 states that the economic effect of issuing such an instrument is substantially
the same as simultaneously issuing a debt instrument with an early settlement
provision and warrants to purchase ordinary shares, or issuing a debt instrument
with detachable share purchase warrants. [IAS 32.29]. However, this analysis is
questionable in the sense that, if a company did issue such instruments separately,
it is extremely unlikely that one would lapse as the result of the exercise of the
other (as is the case on the conversion or redemption of a convertible bond);
• A mandatorily redeemable preference share with dividends paid at the issuer’s
discretion, which effectively comprises:
• a financial liability (the issuer’s obligation to redeem the shares in cash); and
• an equity instrument (the holder’s right to receive dividends if declared).
[IAS 32.AG37].
IAS 32 requires the issuer of a non-derivative financial instrument to evaluate the terms
of the financial instrument to determine whether it contains both a liability and an
equity component. This evaluation is based on the contractual terms of the financial
instruments, the substance of the arrangement and the definition of a financial liability,
financial asset and an equity instrument. If such components are identified, they must
be accounted for separately as financial liabilities, financial assets or equity, [IAS 32.28],
and the liability and equity components shown separately in the statement of financial
position. [IAS 32.29].
This treatment, commonly referred to as ‘split accounting’, is discussed in more detail
in 6.2 to 6.6 below. For simplicity, the discussion below (like that in IAS 32 itself) is
framed in terms of convertible bonds, by far the most common form of compound
financial instrument, but is equally applicable to other types of compound instrument,
such as preference shares with different contractual terms in respect of dividends and
re-payments of principal (see 4.5 above).
3542 Chapter 43
6.1.1
Treatment by holder and issuer contrasted
‘Split accounting’ is to be applied only by the issuer of a compound financial instrument.
The accounting treatment by the holder is dealt with in IFRS 9 and is significantly
different. [IAS 32.AG30]. In particular:
• In the issuer’s financial statements, under IAS 32:
• on initial recognition of the instrument, the fair value of the liability
component is calculated first and the equity component is treated as a
residual; and
• the equity component is never remeasured after initial recognition.
• In the holder’s financial statements, under IFRS 9:
• the instrument fails the criteria for measurement at amortised cost (in
particular the ‘contractual cash flow characteristics test’) and is therefore
carried at fair value through profit or loss (see Chapter 44 at 6).
6.2
Initial recognition – ‘split accounting’
On initial recognition of a compound instrument such as a convertible bond, IAS 32
requires the issuer to:
(a) identify the various components of the instrument;
(b) determine the fair value of the liability component (see below); and
(c) determine the equity component as a residual amount, essentially the issue
proceeds of the instrument less the liability component determined in (b) above.
The liability component of a convertible bond should be measured first, at the fair value
of a similar liability that does not have an associated equity conversion feature, but
including any embedded non-equity derivative features, such as an issuer’s or holder’s
right to require early redemption of the bond, if any such terms are included.
In practical terms, this will be done by determining the net present value of all potential
contractually determined future cash flows under the instrument, discounted at the rate
of interest applied by the market at the time of issue to instruments of comparable credit
status and providing substantially the same cash flows, on the same terms, but without
the conversion option. The fair value of any embedded non-equity derivative features
is then determined and ‘included in the liability component’ – see, however, the further
discussion of this point at 6.4.2 below. [IAS 32.31].
Thereafter the liability component is accounted for in accordance with the
requirements of IFRS 9
, for the measurement of financial liabilities (see Chapter 46).
[IAS 32.31-32].
IAS 32 notes that:
• the equity component of a convertible bond is an embedded option to convert the
liability into equity of the issuer;
• the fair value of the option comprises its time value and its intrinsic value, if any; and
• this option has value on initial recognition even when it is out of the money.
[IAS 32.AG31(b)].
Financial instruments: Financial liabilities and equity 3543
However, not all these features are directly relevant to the accounting treatment, since the
equity component is not (other than by coincidence) recorded at its fair value. Instead, in
accordance with the general definition of equity as a residual, the equity component of the
bond is simply the difference between the fair value of the compound instrument (total
issue proceeds of the bond) and the liability component as determined above. Because of
this ‘residual’ treatment, IAS 32 does not address the issue of how, or whether, the issue
proceeds are to be allocated where more than one equity component is identified. It is
important to note, that the equity component will not be remeasured subsequently.
The methodology of ‘split-accounting’ in IAS 32 has the effect that the sum of the
carrying amounts assigned to the liability and equity components on initial recognition
is always equal to the fair value that would be ascribed to the instrument as a whole. No
gain or loss arises from the initial recognition of the separate components of the
instrument. [IAS 32.31].
This treatment is illustrated in Examples 43.4 and 43.8 below. [IAS 32.IE34-36].
Example 43.4: Convertible bond – basic ‘split accounting’
An entity, whose functional currency is the Euro, issues 2,000 convertible bonds. The bonds have a three-
year term, and are issued at par with a face value of €1,000 per bond, giving total proceeds of €2,000,000.
Interest is payable annually in arrears at a nominal annual interest rate of 6% (i.e. €120,000 per annum). Each
bond is convertible at any time up to maturity into 250 ordinary shares. When the bonds are issued, the
prevailing market interest rate for similar debt without conversion options is 9% per annum. The entity incurs
issue costs of €100,000.
The economic components of this instrument are:
• a liability component, being a discounted fixed rate debt, perhaps with an imputed holder’s put option
(due to the holder’s right to convert at any time), and
• an equity component, representing the holder’s right to convert at any time before maturity. In effect this
is a written call option (from the issuer’s perspective) on American terms (i.e. it can be exercised at any
time until maturity of the bond).
The practical problem with this analysis is that it is not clear what is the strike price of the holder’s options
to put the debt and call for shares, specifically whether it is the €2,000,000 face value of the bonds or the
discounted amount at which they are recorded until maturity. Perhaps for this reason, IAS 32 does not require
the true fair values of these components to be calculated.
Instead the liability component is measured first at the net present value of the maximum potential cash
payments that the issuer could be required to make. The difference between the proceeds of the bond issue
and the calculated fair value of the liability is assigned to the equity component. The net present value (NPV)
of the liability component is calculated as €1,848,122, using a discount rate of 9%, being the market interest
rate for similar bonds having no conversion rights, as shown.
Discount
NPV of
factor
cash flow
Year Cash
flow
€
(at 9%)
€
1 Interest 120,000
1/1.09
110,092
2 Interest 120,000
1/1.092
101,001
3
Interest and principal
2,120,000
1/1.093
1,637,029
Total liability component
1,848,122
Total equity component (balance)
151,878
Total
proceeds
2,000,000
3544 Chapter 43
Next it is necessary to deal with the issue costs of €100,000. In accordance with the requirements of IAS 32
for such costs (see 8.1 below), these would be allocated to the liability and equity components on a pro rata
basis. This would give the following allocation of the net issue proceeds.
Liability
Equity
component
component
Total
€
€
€
Gross proceeds (allocated as above)
1,848,122
151,878
2,000,000
Issue costs (allocated pro rata to
gross proceeds)
(92,406)
(7,594)
(100,000)
Net proceeds
1,755,716
144,284
1,900,000
The €144,284 credited to equity is not subsequently remeasured (see 6.2.1 below). On the assumption that
the liability is not classified as at fair value through profit or loss, the €1,755,716 liability component would
be accounted for under the effective interest rate method. It should be borne in mind that, after taking account
of the issue costs, the effective interest rate is not the 9% used to determine the gross value of the liability
component, but 10.998%, as shown below.
Interest
Year Liability
b/f
at 10.998%
Cash paid
Liability c/f
€
€
€
€
1 1,755,716
193,094
(120,000)
1,828,810
2 1,828,810
201,134
(120,000)
1,909,944
3 1,909,944
210,056
(2,120,000)
–
Total finance cost 604,284
The total finance cost can be proved as follows:
€
Cash interest at 6%
360,000
Gross issue proceeds originally allocated to equity component
151,878
Issue costs allocated to liability component
92,406
604,284
6.2.1
Accounting for the equity component
On initial recognition of a compound financial instrument, the equity component (i.e.
the €144,284 identified in Example 43.4 above) is credited direct to equity and is not
subsequently remeasured. IAS 32 does not prescribe:
• whether the credit should be to a separate component of equity (although a
transitional provision relating to the February 2008 amendment of IAS 32 suggests
that there is such a requirement); or
• if the entity chooses to treat it as such, how it should be described.
This ensures that there is no conflict between, on the one hand, the basic requirement
of IAS 32 that there should be a credit in equity and, on the other, the legal requirements
of various jurisdictions as to exactly how that credit should be allocated within equity.
After initial recognition, the classification of the liability and equity components of a
convertible instrument is not revised, for example as a result of a change in the likelihood
that a conversion option will be exercised, even when exercise of the option may appear
to have become economically advantageous to some holders. IAS 32 points out that
Financial instruments: Financial liabilities and equity 3545
holders may not always act in the way that might be expected because, for example, the
tax consequences resulting from conversion may differ among holders. Furthermore, the
likelihood of conversion will change from time to time. The entity’s contractual obligation
to make future payments remains outstanding until it is extinguished through conversion,
maturity of the instrument or some other transaction. [IAS 32.30].
The amount originally credited to equity is subsequently neither remeasured nor
reclassified to profit or loss. Thus, as illustrated by Example 43.5 above, the effective interest
rate shown in profit or loss for a simple convertible bond will be equivalent to the rate that
would have been paid for non-convertible debt. In effect, the dilution of shareholder value
represented by the embedded conversion right is shown as an interest expense.
However, on conversion of a convertible instrument, it may be appropriate to transfer
the equity component within equity (see 6.3.1 below).
6.2.2 Temporary
differences
arising from split accounting
In many jurisdictions it is only the cash interest paid, and sometimes also the issue costs,
that are deductible for tax purposes, rather than the full amount of the finance cost charged
under IAS 32. Moreover, some of these costs may be deductible in periods different from
those in which they are recognised in the financial statements. These factors will give rise
to temporary differences between the carrying value of the liability component of the bond
and its tax base, giving rise to deferred tax required to be accounted for under IAS 12 –
Income Taxes (see Chapter 29, particularly at 6.1.2 and 7.2.8).
6.3
Conversion, early repurchase and modification
6.3.1
Conversion at maturity
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 700
