International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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6.4.1
Determining the components of a compound instrument
The most difficult aspect of ‘split accounting’ is often the initial assessment of whether
the instrument consists of different components and if it does, what the various
components of the instrument actually are. In the examples above, it is fairly clear that
the instruments consist of different components and what the various components are.
However, in some instruments the analysis is far from straightforward, as illustrated by
Example 43.7 below.
Example 43.7: Analysis of compound financial instrument into components
An entity issues a bond for €100, paying an annual cash coupon of 5% on the issue price and mandatorily
convertible after five years on the following terms. If, at the date of conversion, the entity’s share price is
€1.25 or higher, the holder will receive 80 shares. If the entity’s share price is €1.00 or lower, the holder will
receive 100 shares. If the entity’s share price is in the range €1.00 to €1.25, the holder will receive such
number of shares (between 80 and 100) as have a fair value of €100.
Any analysis must begin by determining whether the bond as whole is a non-derivative
instrument. This is the case, since the issuing entity receives full consideration for its issue.
Financial instruments: Financial liabilities and equity 3551
The next step is to assess whether the instrument consists of different components and, if
it does, to break the instrument down into these components so as to identify any equity
components in the whole.
The difficulty of this assessment is evidenced by two requests received by the
Interpretations Committee to address the accounting for two instruments with
substantially the same features as the one in Example 43.7 above but with an additional
early settlement option for the issuer, to settle the instrument at any time by delivering
a maximum (fixed) number of shares (see 6.6.3.A below).25 While the request focused
only on the additional early settlement option, and not on the classification of the ‘basic’
instrument (an instrument with the features described in Example 43.7 above), the
accounting treatment of the ‘basic instrument’ was added to the Interpretations
Committee’s agenda. It was discussed during the January 2014 and May 2014
Interpretations Committee meetings.26
Four alternative views with significantly different accounting outcomes, ranging from
classifying the whole financial instrument as a financial liability to various combinations
of financial liabilities, equity instruments and/or derivative financial liabilities, were
considered by the Interpretations Committee. In the end the Interpretations Committee
noted that:
• the issuer’s obligation to deliver a variable number of the entity’s own equity
instruments is a non-derivative that meets the definition of a financial liability in
paragraph 11(b)(i) of IAS 32 in its entirety (see 3 and 4.1 above); and
• the definition of a liability in IAS 32 does not have any limits or thresholds
regarding the degree of variability that is required.
Therefore, the contractual substance of the instrument is a single obligation to deliver a
variable number of equity instruments at maturity, with the variation based on the value
of those equity instruments. The Interpretations Committee noted further that such a
single obligation to deliver a variable number of own equity instruments cannot be
subdivided into components for the purposes of evaluating whether the instrument
contains a component that meets the definition of equity. Even though the number of
equity instruments to be delivered is limited and guaranteed by the cap and the floor,
the overall number of equity instruments that the issuer is obliged to deliver is not fixed
and therefore the entire obligation meets the definition of a financial liability.
The Interpretations Committee noted that the cap and the floor are embedded
derivative features, whose values change in response to the price of the issuer’s equity
shares. Therefore, assuming that the issuer has not elected to designate the entire
instrument under the fair value option, the issuer must separate those features and
account for the embedded derivative features separately from the host liability
contract, at fair value through profit or loss in accordance with IFRS 9 (see Chapter 42
at 4 and 5).
The fact that the issue was submitted to the Interpretations Committee in the first place
together with the fact that four possible accounting views were drawn up under the
guidance of IAS 32, evidences how difficult and judgemental any analysis of increasingly
complex instruments can be under the provisions of IAS 32.
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6.4.2
Compound instruments with embedded derivatives
As noted above, in order to qualify for split accounting, a financial instrument, when
considered as a whole, must be a non-derivative instrument. However, one or more of its
identified components may well be embedded derivatives. Indeed, the conversion right in
any convertible bond represents a holder’s call option whereby the entity can be required
to issue a fixed number of shares for a fixed consideration (the ‘fixed stated principal’ of
the bond – see 6.3.2.A above), which is accordingly identified as an equity component.
A bond may well contain other (non-equity) derivatives, such as options for either the
issuer or the holder to require early repayment or conversion or to extend the period until
conversion. The detailed guidance in IAS 32 requires the fair value of any embedded non-
equity derivative features to be determined and included in the liability component when
split accounting is applied (see 6.2 above). [IAS 32.31]. They are then subject to the normal
requirement of IFRS 9 for embedded derivatives to be accounted for separately if they
are not considered to be closely related to the host contract (see Chapter 42 at 5).
The issuer of a compound financial instrument with other embedded derivatives is
therefore required to go through the following steps:
• First step: determine the fair value of the liability component that does not have
an associated equity conversion feature but including any embedded non-equity
derivatives features;
• Second step: determine the equity component as a residual amount by deducting
the fair value of the liability component, including any embedded non-equity
derivative features, from the fair value of the compound instrument (essentially its
issue proceeds); and
• Third step: assess whether the embedded non-equity derivative features are
closely related to the host liability component. Any not closely related embedded
non-equity derivative features are accounted for separately and therefore
separated from the host liability component (see Chapter 42 at 4 and 5).
Note, on initial recognition, the sum of the initial carrying amounts of the various
components, determined as indicated above, must equal the overall fair value of the
compound instrument.
The separation of the liability and equity components of a compound financial
instrument with multiple embedded derivative features is demonstrated in
Ex
ample 43.8 below which is based on an illustrative example in IAS 32. [IAS 32.IE37-38].
6.4.2.A
Issuer call option – ‘closely related’ embedded derivatives
Example 43.8: Convertible bond – split accounting with multiple embedded
derivative features
The proceeds received on the issue of a convertible bond, callable at par, are £60 million, which equals the
nominal amount of the convertible bond. The value of a similar bond without a call or equity conversion option
is £57 million. Based on an option-pricing model, it is determined that the value to the entity of the embedded
call feature in a similar bond without an equity conversion option is £2 million. In this case, the value is allocated
to the liability component so as to reduce the liability component to £55 million (£57m – £2m) and the value
allocated to the equity component is £5 million (£60m – £55m). Because IFRS 9 requires the embedded
derivative assessment to be done before separating the equity component and the call option is at par, the option
is considered to be clearly and closely related and therefore not separated from the liability host contract.
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Where (as is often the case) a convertible bond is callable at par, the call option would
not be a separable derivative. IFRS 9 states that a call option is generally closely related
to the host debt contract if the exercise price is approximately equal to the amortised
cost of the host on each exercise (which would not, prima facie be the case). However,
as an exemption to the general rule, IFRS 9 requires this assessment to be made in
respect of any embedded call, put or prepayment option in a convertible bond before
separating the equity component. [IFRS 9.B4.3.5(e)]. This has the effect that an issuer’s call
over a convertible bond at par is effectively deemed to be equal to amortised cost for
the duration of the instrument. This is discussed further in Chapter 42 at 5.
6.4.2.B
Issuer call option – ‘not closely related’ embedded derivatives
If a non-equity embedded derivative is considered not to be closely related to the host
contract then it should be accounted for separately. If, in Example 43.8 above, the issuer
call option were at an amount that was not approximately equal to amortised cost, and
not intended to reimburse the approximate present value of lost interest (see Chapter 42
at 5), say at par plus £5 million, then the call option would not be considered clearly and
closely related and therefore should be accounted for separately. The issuer in
Example 43.8 would therefore record a derivative financial asset at its fair value of
£2 million, assuming it would have the same fair value as in Example 43.8, a liability
component of £57 million and an equity component of £5 million. The call option
would subsequently be remeasured at fair value through profit or loss.
There are cases where over-enthusiastic trawling for embedded derivatives may dredge
up results so counter-intuitive that it is hard to believe that they were really intended
by the IASB, as illustrated by Example 43.9 below.
Example 43.9: Foreign currency denominated equity instrument with issuer’s
redemption right
An entity with a functional currency of pounds sterling issues a euro-denominated capital instrument for
€145 million (equivalent to £100 million at the date of issue). Coupons on the instrument are paid entirely at
the entity’s discretion. The entity has the right, but not the obligation, in certain circumstances to redeem the
instrument (in Euros) for an amount equal to the original issue proceeds.
Taken as a whole, this is an equity instrument, because it gives rise to no obligation to transfer cash or other
financial assets to the holder. However, the issuer’s right to redeem, if considered in isolation is not an equity
instrument, but a financial asset (a call option over own equity), since it is a derivative involving the purchase
of a fixed number of equity instruments for €145 million which, although fixed in euros, is variable when
translated into sterling. Suppose that the fair value of the call option, at the date of issue was £15 million.
This analysis would result in the following accounting entry on issue of the instrument:
£m
£m
Cash 100
Call option (statement of financial position)
15
Equity
115
In our view, it would be inappropriate to show an increase in net assets of £115 million, when the only real
transaction has been the raising of £100 million of equity for cash. In this particular case, this treatment is, in
our view, not required since paragraph 28 of IAS 32 requires split accounting to be applied only where an
instrument is determined to contain ‘both a liability and an equity component’. In this case, there is no liability
component, since the embedded derivative that has potentially been identified is, and can only ever be, an
asset; accordingly, ‘split accounting’ is not required.
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6.5 Other
issues
The following issues discussed earlier in this chapter are of particular relevance to
convertible bonds:
• the Interpretations Committee’s conclusion that a fixed amount of cash
denominated in a currency other than the entity’s functional currency is not a
‘fixed amount’ of cash (see 5.2.3 above and 6.6.4 and 6.6.4.A below); and
• the treatment of instruments settled with equity instruments the number of which
varies to reflect major capital restructurings before settlement (see 5.1.2 above).
These and other issues noted at various points above reinforce an increasing concern
that the ‘split accounting’ rules in IAS 32 are implicitly based on a bond with terms much
more straightforward than those of many – if not most – bonds currently in issue. See 12
below for possible future developments.
6.6
Common forms of convertible bonds
6.6.1
Functional currency bond convertible into a fixed number of shares
The most common form of convertible bond, a functional currency bond convertible
into a fixed number of own equity instruments at the discretion of the holder, is
discussed in Example 43.4 at 6.2 above.
6.6.2
Contingent convertible bond
A contingent convertible bond is a bond that is convertible, at the option of the holder,
only on the occurrence of a contingent event outside of the control of the holder or the
issuer. If the contingent event occurs then the holder has the option, but not the
obligation, to convert. If the contingent event does not occur, then the bond will be
settled in cash at maturity.
The fact that conversion is only contingent does not mean the instrument has no equity
component. If, on occurrence of the contingent event, exercise of the conversion option
would result in the exchange of a fixed number of the issuer’s own equity instruments
for a fixed amount of cash (in the functional currency of the issuing entity), the
conversion option would meet the definition of an equity instrument under IAS 32 and
the overall instrument would be treated as a compound instrument.
6.6.3
Mandatorily convertible bond
> A mandatorily convertible bond is an instrument that, at a certain time in the future,
converts into shares of the issuing entity, rather than the conversion being at the option
of either the holder or the issuer of the bond. The classification of a mandatorily
convertible bond on initial recognition as debt or equity depends on:
• how the convertible bond will be settled; and
• whether the issuer is required to pay interest up to the point of conversion.
If the fixed stated principal will be settled through delivery of a fixed number of the
issuer’s own shares, and the principal of the convertible bond is in the same currency as
the functional currency of the issuing entity, then this feature of the bond is an equity
instrument and accounted for as such (see 4.1 and 5.2.3 above). If interest on the bond
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is payable only at the discretion of the entity, then there is no liability component, and
the entire bond is classified as an equity instrument. If, however, the entity is required
to pay interest, the obligation to pay interest establishes a liability component, which is
measured at the present value of the required interest payments.
If settlement can only occur through the delivery of a variable number of the issuer’s
own shares, calculated so that the fair value of these shares issued equals the principal
amount (see 5.2.1 above), and the entity is required to pay interest then the entire bond
is classified as a financial liability.
Example 43.10: Mandatorily convertible bond classified as equity
An entity, with a functional currency of Euro, issues 2,000 convertible bonds with a nominal value of €1,000
per bond, giving total proceeds of €2,000,000. The bonds have a three-year term, and interest is payable, at
the discretion of the entity, annually in arrears at a nominal annual interest rate of 6% (i.e. €120,000 per
annum). At maturity of the bond each bond converts into 250 ordinary shares. Because the conversion option
meets the definition of an equity instrument and payment of interest is at the discretion of the entity, the entire
instrument is classified as an equity instrument. The entity records the following accounting entry.