On conversion of a convertible instrument at maturity, IAS 32 requires the entity to
derecognise the liability component and recognise it as equity. There is no gain or loss
on conversion at maturity. [IAS 32.AG32].
Thus, for example, if the bond in Example 43.4 above were converted at maturity, the
accounting entry required by IAS 32 would be:
€
€
Liability
2,000,000
Equity 2,000,000
The precise allocation of the credit to equity (e.g. as between share capital, additional
paid-in capital, share premium, other reserves and so on) would be a matter of local
legislation. In addition, IAS 32 permits the €144,284 originally allocated to the equity
component in Example 43.4 above to be reallocated within equity. [IAS 32.AG32].
6.3.2
Conversion before maturity
6.3.2.A
‘Fixed stated principal’ of a bond
The consideration given for the issue of equity instruments on conversion of a bond is
the discharge by the holder of the issuer from the liability to pay any further interest or
principal payments on the bond. If conversion can take place only at maturity, the
3546 Chapter 43
amount of the liability transferred to equity on conversion will always (as in
Example 43.4 at 6.2 above) be €2,000,000. Hence, the conversion right involves the
delivery of a fixed number of shares for the waiver of the right to receive a fixed amount
of cash and so is clearly an equity instrument.
However, the bond in Example 43.4 allows conversion at some point before the full
term. Therefore, conversion might occur at the end of year 2, when the carrying value
of the bonds would have been accreted to only €1,909,944. Hence, the carrying amount
of the liability that is forgiven on conversion can vary depending on when conversion
occurs. This begs the question as to whether the conversion right now involves the
delivery of a fixed number of shares for the waiver of the right to receive a variable
amount of cash, suggesting that it is no longer an equity instrument.
It is for this reason, in our view, that IAS 32 defines as an equity instrument one that
involves the exchange of a fixed number of shares for the ‘fixed stated principal’
rather than the ‘carrying amount’ of a bond. [IAS 32.22]. In other words, IAS 32 regards
the ‘fixed stated principal’ of the bond in Example 43.4 as a constant €2,000,000.
The intention is to clarify that the variation in the carrying amount of the bond
during its term does not preclude the conversion right from being classified as an
equity instrument.
6.3.2.B Accounting
treatment
IAS 32 refers to the treatment summarised in 6.3.1 above being applied on conversion
‘at maturity’. This begs the question of the treatment required if a holder converts prior
to maturity (as would have been possible under the terms of the bond in Example 43.4).
As noted in 6.3.2.A above, IAS 32 concludes that the equity component of the bond is
an equity instrument on the grounds that it represents the holder’s right to call for a
fixed number of shares for fixed consideration, in the form of the ‘fixed stated principal’
of the bond.
It could be argued that the logical implication of this is that, on a holder’s early
conversion of the bond in Example 43.4 above, the issuer should immediately recognise
a finance cost for the difference between the then carrying amount of the liability
component of the bond and the fixed stated principal of €2,000,000. This would create
a liability of €2,000,000 immediately before conversion, so as to acknowledge that the
strike price under the holder’s call option is the waiver of the right to receive a fixed
stated principal of €2,000,000, rather than whatever the carrying value of the bond
happens to be at the time.
However, we take the view, supported by general practice, that all that is required is to
transfer to equity the carrying value of the liability at the date of conversion, as
calculated after accrual of finance costs on a continuous basis, rather than at the amount
shown in the most recently published financial statements. In such a case, the
consideration for the issue of equity instruments is the release, by the bondholder, of
the issuer from its liability to make future contractual payments under the bond,
measured at the net present value of those payments.
IFRIC 19 (which generally applies to debt for equity swaps) does not apply to the
conversion of a convertible instrument in accordance with its original terms (see 7 below).
Financial instruments: Financial liabilities and equity 3547
6.3.2.C
Treatment of embedded derivatives on conversion
IAS 32 does not specifically address the treatment of any separated non-equity
embedded derivatives outstanding at the time of conversion. The issue of principle is
that, when a holder exercises its right to convert, it is effectively requiring the issuer to
issue equity in consideration for the bondholder ceding its rights. These may include
any right to receive future payments of principal and/or interest or to require early
repayment of the bond. It seems entirely appropriate that any amounts carried in
respect of such rights, including those reflected in the carrying amount of separated
embedded derivatives, should be transferred to equity on conversion.
Where, however, conversion has the effect of removing an issuer’s right (for example,
to compel early redemption or conversion), this could be seen as a loss to the issuer
rather than as consideration given by the holder for an issue of equity. In our view,
however, the loss of such a right by the issuer on conversion by the holder simply
represents a reduction in the proceeds received for the issue of equity, and should
therefore by accounted for as a charge to equity (see also 8.1 below).
6.3.3
Early redemption or repurchase
It is not uncommon for the issuer of a convertible bond to redeem or repurchase it before
the end of its full term, either through exercise of rights inherent in the bond, such as an
embedded issuer call option, or through subsequent negotiation with bondholders.
IAS 32 contains guidance for the accounting treatment of an early redemption or
repurchase of compound instruments following a tender offer to bondholders
(see 6.3.3.A below).
It is not entirely clear whether this guidance applies only to redemption pursuant to a
subsequent negotiation with bondholders, or whether it also applies where redemption
occurs through exercise of a right inherent in the original terms of the bond. We
therefore believe an entity has an accounting policy choice if redemption is based on a
right inherent in original terms of the bond, such as an embedded issuer call option at
par that was allocated to the liability component and considered to be clearly and
closely related to the host contract (see 6.3.3.B below).
6.3.3.A
Early repurchase through negotiation with bondholders
When an entity extinguishes a convertible instrument before maturity through an early
redemption or repurchase in which the original conversion privileges are unchanged,
&nb
sp; IAS 32 requires the entity to allocate the consideration paid and any transaction costs
for the repurchase or redemption to the liability and equity components of the
instrument at the date of the transaction. [IAS 32.AG33].
It is not entirely clear what is meant by a ‘redemption or repurchase in which the original
conversion privileges are unchanged’. However, we assume that it is intended to imply
that the repurchase must occur without modification of the original terms of the
compound instrument, and at a price representing a fair value for the instrument on its
original terms. A repurchase based on a modification of the original terms of the
instrument, or at a price implying a modification of them, should presumably be dealt
with according to the provisions of IAS 32 for the modification of a compound
3548 Chapter 43
instrument (see 6.3.4 below) or those in IFRS 9 for the exchange and modification of
debt (see Chapter 48 at 6.2).
The method used for allocating the consideration paid and transaction costs to the
separate components should be consistent with that used in the original allocation to
the separate components of the proceeds received by the entity when the convertible
instrument was issued (see 6.2 above). [IAS 32.AG33].
The issuer is therefore required to:
• determine the fair value of the liability component and allocate this part of the
purchase price to the liability component;
• allocate the remainder of the purchase price to the equity component; and
• allocate the transaction costs between the liability and equity component on a pro
rata basis.
Once this allocation of the consideration has been made:
• the difference between the consideration allocated to the liability component and
the carrying amount of the liability is recognised in profit or loss; and
• the amount of consideration relating to the equity component is recognised
in equity. [IAS 32.AG34].
The treatment of a negotiated repurchase at fair value of a convertible instrument is
illustrated by Example 43.5 below, which is based on an illustrative example in IAS 32.
[IAS 32.IE39-46].
Example 43.5: Early repurchase of convertible instrument
For simplicity this example:
• assumes that at inception the face amount of the instrument was equal to the carrying amount of its liability
and equity components in the financial statements – i.e. there was no premium or discount on issue; and
• ignores transaction costs and tax.
On 1 January 2014, an entity issued a convertible bond with a face value of €100 million maturing on
31 December 2023, at which point the holder may opt for repayment of €100 million or conversion into
4 million shares. Interest is paid half-yearly in arrears at a nominal annual interest rate of 10% (i.e. €5m per
half year). At the date of issue, the entity could have issued non-convertible debt with a ten-year term bearing
interest at 11%. On issue, the carrying amount of the bond was allocated as follows:
€m
Present value of the principal – €100m payable at the end of ten years1
34.3
Present value of the interest – 20 6-monthly payments of €5m2
59.7
Total liability component
94.0
Equity component (balance)
6.0
Proceeds of the bond issue
100.0
The amounts above are discounted using a semi-annual rate of 5.5% (11%÷2) as follows:
1 €100m/1.05520
2
€5m × (1/1.055 +1/1.0552+ 1/1.0553+ ... 1/1.05520)
On 1 January 2019, the entity makes a tender offer to the holder of the bond to repurchase the bond at its then
fair value of €170 million, which the holder accepts. At the date of repurchase, the entity could have issued
non-convertible debt with a five-year term with interest payable half-yearly in arrears at an annual coupon
interest rate of 8%.
Financial instruments: Financial liabilities and equity 3549
At the time of repurchase, the carrying amount of the liability component of the bond, discounted at the
original semi-annual rate of 5.5% is as follows.
€m
Present value of the principal – €100m payable at the end of five years1
58.5
Present value of the interest – 10 6-monthly payments of €5m2
37.7
Carrying value of liability component
96.2
10
1
€100m/1.055
2
3
10
2
€5m × (1/1.055 +1/1.055 + 1/1.055 + ... 1/1.055 )
The fair value of the liability component of the bond, discounted at the current semi-annual rate of 4% (8%÷2)
is as follows.
€m
Present value of the principal – €100m payable at the end of five years1
67.6
Present value of the interest – 10 6-monthly payments of €5m2
40.5
Fair value of liability component
108.1
10
1
€100m/1.04
2
3
10
2
€5m × (1/1.04 +1/1.04 + 1/1.04 + ...1/1.04 )
The fair value calculation indicates that, of the repurchase price of €170 million, €108.1 million is to be
treated as redeeming the liability component of the bond, and the balance of €61.9 million as redeeming the
equity component. This gives rise to the accounting entry:
€m €m
Liability component of bond
96.2
Equity 61.9
Debt settlement expense (profit or loss)
11.9
Cash
170.0
The debt settlement expense represents the difference between the carrying value of the debt component
(€96.2m) and its fair value (€108.1m).
Any costs of the repurchase would have been allocated between profit or loss and equity in proportion to the
fair value of the liability and equity components at the time of redemption.
6.3.3.B
Early repurchase through exercising an embedded call option
It is not entirely clear whether the guidance in 6.3.3.A above applies only on early
redemption or repurchase to a subsequent negotiation with bondholders, or whether it
also applies where redemption occurs through exercise of rights inherent in the terms
of the bond (for example an issuer call option at par allocated to the liability component
and considered to be clearly and closely related to the host contract).
One way of accounting for such redemptions would be by applying the accounting
treatment as discussed under 6.3.3.A above.
If, however, this early repayment option was determined, on initial recognition of the
convertible bond, to be clearly and closely related to the liability host contract
(see 6.4.2.A below), then it might be argued that the general measurement rules of
IFRS 9 apply. In such a case the liability (including the embedded call option) would be
measured at amortised cost (assuming that it was not designated at fair value through
profit or loss on initial recognition). Accounting under the amortised cost method is
3550 Chapter 43
based on an effective interest rate, calculated initially based on expected future cash
flows. Any change in those expected cash flows is reflected in the carrying amount of
the financial instrument, by computing the present value of the revised estimated future
cash flows at the instrument’s original effective interest rate, with any difference from
the previous amortised cost carrying amount recorded in profit or loss. [IFRS 9.B5.4.6].
A change in the expected repayment date would therefore require the amortised cost of the
financial liability component to be remeasured. This treatment has the effect that the overall
repayment amount at par is allocated to the liability portion of the compound instrument.
6.3.4 Modification
An entity may amend the terms of a convertible instrument to induce early conversion,
for example by offering a more favourable conversion ratio or paying other additional
consideration in the event of conversion before a specified date. The difference, at the
date the terms are amended, between:
• the fair value of the consideration the holder receives on conversion of the
instrument under the revised terms; and
• the fair value of the consideration the holder would have received under the
original terms,
is recognised as a loss in profit or loss. [IAS 32.AG35]. IAS 32 illustrates this treatment, as
shown in Example 43.6 below. [IAS 32.IE47-50].
Example 43.6: Modification of the terms of a bond to induce early conversion
Suppose that the entity in Example 43.5 at 6.3.3.A above wished, on 1 January 2019, to induce the bondholder
to convert the bond early. The original terms of the bond allowed for conversion into 4 million shares. The
entity offers the bondholder the right to convert into 5 million shares during the period 1 January to
28 February 2019. The market value of the entity’s shares is €40 per share.
The enhanced conversion terms offer the bondholder the right to receive an additional 1 million shares.
Accordingly, the entity recognises a cost of €40m (1m shares × share price €40/share) in profit or loss.
6.4
The components of a compound instrument
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 701
