€
€
Cash 2,000,000
Equity
2,000,000
Example 43.11: Mandatorily convertible bond classified as a compound
instrument
Assume the same fact pattern as in Example 43.10 above, except that the entity has an obligation to pay
interest annually in arrears at a nominal annual interest rate of 6% (i.e. €120,000 per annum). The obligation
to pay interest over three years represents a liability of the issuing entity at the net present value, using a
discount rate of 9%, which is the market interest rate.
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 120,000
1/1.093
92,662
Total liability component
303,755
Total equity component (balance)
1,696,245
Total
proceeds
2,000,000
The entity records the following accounting entry.
€
€
Cash 2,000,000
Equity
1,696,245
Liability
303,755
6.6.3.A
Bond which is mandatorily convertible into a variable number of shares
with an option for the issuer to settle early for a maximum number of
shares
At its meeting in July 2013, the Interpretations Committee considered the IAS 32
classification for a financial instrument that is mandatorily convertible into a variable
3556 Chapter 43
number of shares, subject to a cap and floor, but with an issuer option to settle by
delivering the maximum (fixed) number of shares.27 This is a financial instrument with
essentially the same features as the one described in Example 43.7 above, but with an
additional option for the issuer to settle the instrument at any time before maturity
(see 6.4.1 above for IAS 32 classification considerations for the ‘basic financial
instrument’, ignoring the early settlement option). If the issuer chooses to exercise its
early settlement option, it must deliver the maximum number of shares specified in the
contract (e.g. 100 shares in Example 43.7 and pay in cash all of the interest that would
have been payable if the instrument had remained outstanding until its maturity date (a
so called ‘make-whole provision’).
Applying the IAS 32 definitions of a financial liability and of an equity instrument to
such a financial instrument would result in accounting for it as a compound instrument
(i.e. a financial instrument consisting of an equity element and a financial liability
element). IAS 32 states that a non-derivative financial instrument is an equity instrument
if the instrument will be settled in the issuer’s own equity instruments and includes no
contractual obligation for the issuer to deliver a variable number of its own equity
instruments. [IAS 32.11(b)(i)]. With the early settlement option, the issuer has the right to
avoid delivering a variable number of shares. A portion of the financial instrument
would therefore meet the definition of equity and would be accounted for as such. The
interest payments on the instrument, on the other hand, impose a contractual obligation
on the issuer to deliver cash in all cases and therefore meet the definition of a financial
liability and would be accounted for as such.
However, this analysis ignores the fact that in exercising the early settlement option, the
issuer must deliver at an earlier time a potentially greater number of its own shares, plus
all the interest in cash which would have been payable over the instrument’s life. The
issuer can avoid delivering a variable number of its own shares but only by giving away
a potentially larger amount of economic value. The question asked of the
Interpretations Committee was whether such an early settlement option should be
considered when classifying the financial instrument under IAS 32.
In its analysis, the Interpretations Committee noted that the definitions of financial
asset, financial liability and equity instrument in IAS 32 are based on the financial
instrument’s contractual rights and contractual obligations.28 However, IAS 32 requires
the issuer of a financial instrument to classify the instrument in accordance with the
substance of the contractual arrangement. [IAS 32.15]. An issuer cannot assume that a
financial instrument (or any component) meets the definition of an equity instrument
simply because the issuer has the contractual right to settle the financial instrument by
delivering a fixed number of equity instruments. The issuer would need to consider
whether the early settlement option is substantive and, if it was concluded that it lacks
substance, then it should be ignored for the classification assessment of the instrument.
It was noted that the guidance in paragraph 20(b) of IAS 32 is relevant because it
provides an example of a situation in which one of an instrument’s settlement
alternatives is excluded from the classification assessment. Specifically, the example in
that paragraph describes an instrument that the issuer will settle by delivering either
cash or its own shares, and states that one of the settlement alternatives should be
excluded from the classification assessment in some circumstances (see 5.2.4 above).
Financial instruments: Financial liabilities and equity 3557
To determine whether the early settlement option is substantive, the issuer would
need to understand whether there are actual economic or business reasons that
would lead the issuer to exercise the option. In making that assessment, the issuer
could consider whether the instrument would have been priced differently if the
issuer’s early settlement option had not been included in the contractual terms. The
Interpretations Committee also noted that factors such as the term of the instrument,
the width of the range between the cap and the floor, the issuer’s share price and the
volatility of the share price could be relevant to the assessment of whether the
issuer’s early settlement option is substantive. For example, the early settlement
option may be less likely to have substance – especially if the instrument is short-
lived – if the range between the cap and the floor is wide and the current share price
would equate to the delivery of a number of shares that is close to the floor. That is
because the issuer may have to deliver significantly more shares to settle early than
it may otherwise be obliged to deliver at maturity. The Interpretations Committee
considered that in light of its analysis of the existing IFRS requirements, it would not
add this issue to its agenda.
6.6.3.B
Bond which is mandatorily convertible into a variable number of shares
upon a contingent ‘non-viability’ event
Since the financial crisis, regulators have been looking to strengthen the capital base of
financial institutions, particularly in the banking sector. Rising requirements for capital
adequacy have resulted in banks lo
oking into new forms of capital instruments. One
form of such capital instruments are financial instruments that convert into a variable
number of the issuer’s own ordinary shares if the institution breaches a minimum
regulatory requirement. This type of contingent event is called a ‘non-viability’ event.
While the exact terms of these instruments vary in practice, they do generally come
with the following key features:
• no stated maturity but the issuer can call the instrument for the par amount of cash;
• while the instrument has a stated interest rate (e.g. 5%), payment of interest is at
the discretion of the issuer; and
• if the issuer breaches a minimum regulatory requirement (e.g. ‘Tier 1 Capital ratio’),
the instrument mandatorily converts into a variable number of the issuer’s own
ordinary shares. The number of shares delivered would depend on the current
share price, i.e. the issuer must deliver as many shares as are worth the par amount
of the instrument at conversion.
In July 2013 the Interpretations Committee considered a request to clarify the
accounting for such instruments.29 In its tentative agenda decision, the Interpretations
Committee noted that the instrument is a compound instrument that is composed of the
following two components:
• a liability component, which reflects the issuer’s obligation to deliver a variable
number of its own equity instruments if the contingent non-viability event occurs; and
• an equity component, which reflects the issuer’s discretion to pay interest.
To measure the liability component, the Interpretations Committee noted that the
issuer must consider the fact that the contingent non-viability event could occur
3558 Chapter 43
immediately because it is beyond the control of the issuer. Hence the liability
component must be measured at the full amount that the issuer could be required to pay
immediately. The equity component would be measured as a residual and thus would
be measured at zero, because the instrument is issued at par and the value of the variable
number of shares that will be delivered on conversion is equal to that fixed par amount.
The Interpretations Committee received 12 comment letters on the tentative agenda
decision, many accepting that the Interpretation Committee’s view is one way of
analysing the financial instrument under IAS 32, but generally expressing the view that
the relevant guidance in IAS 32 is unclear and that equally valid arguments could be
made for other views. For instance, one view discussed at the time was that, when
measuring the liability component, the issuer should consider the expected timing of
the contingent non-viability event occurring and discount the liability accordingly.
Therefore, if the issuer believed that the contingency would not occur in the near-term,
the liability component would be recognised at an amount of less than par. The
comments provided focused in particular on (a) the measurement of the liability
component and (b) whether interest paid on the instrument, if any, would need to be
recognised in equity or as interest in profit or loss. Based on the comments received,
the Interpretations Committee decided, after further discussions in its January 2014
meeting, not to add this issue to its agenda and noted that the scope of the issues raised
in the submission was too broad to be addressed in an efficient manner.30 There is
therefore the potential for diversity in practice until this issue is clarified by the IASB.
This is illustrated by the following example:
Example 43.12: Convertible bond mandatorily convertible upon ‘non-viability’
event
A bank issues €100 million of contingent convertible bonds. The bonds notionally pay fixed interest of 7%
annually however interest payments are at the sole discretion of the issuer providing that no dividend is paid
on the ordinary shares of the issuer. The bonds are perpetual, but the issuer has the right to call the shares
after five years and on every succeeding fifth anniversary thereafter.
The instrument is immediately converted into ordinary shares with a fair value equal to the par value of the
bonds upon either:
• the bank’s fully loaded Common Equity Tier 1 (CET 1) ratio falling below 7%; or
• the local regulator declaring a non-viability event.
The instrument has both debt features, such as the contingent settlement provision
which requires settlement in a variable number of shares upon a non-viability event,
and equity features, such as the perpetual nature of the instrument and the discretionary
interest payments. As discussed above there are a number of views that could be taken
on how to classify this instrument.
Based on the Interpretations Committee’s discussion, the view could be taken that the
bonds are a compound instrument and that because the contingent settlement provision
might be activated immediately, a liability for the par amount of the bond should be
recorded. The equity component of the instrument representing the discretionary
interest payments would therefore have no value.
However this could be viewed as odd given that there is usually no expectation that a
trigger event will occur when the instrument is first issued. As such it might be
Financial instruments: Financial liabilities and equity 3559
considered to be more reasonable to estimate when a trigger event is most likely to
occur and calculate the liability component on that basis with the residual amount being
classified as equity.
There is a further argument that the whole instrument falls within the definition of a
liability rather than a compound instrument as the entity may be required to deliver a
variable number of shares for a non-derivative instrument. [IAS 32.11(b)(i)].
The conversion trigger itself is not a separable embedded derivative as redemption at
amortised cost is regarded as being closely related to the host contract. This is the case
even if the debt and equity components of the instrument are separated, as the
evaluation of the embedded derivative has to be performed prior to the separation of
the equity component. [IFRS 9.B4.3.5(e)].
Similarly the call option exercisable to extend the term of the instrument is not a
separable embedded derivative as the option is at par and so is also closely related.
Any discretionary interest payments would be classified depending on whether the host
is classified as a liability, in which case the payments would be interest, or as a
compound instrument, in which case payments would be dividends.
A further complication arises with the introduction of bank resolution regimes, such as
the European Union’s Banking Recovery and Resolution Directive (BRRD). These
regimes subject certain financial instruments to bail-in, where banking regulators have
the power to write down an instrument or convert it into another CET 1 instrument at
their discretion.
As the right to convert the instrument is at the option of the regulator and not the issuer
it is arguable that the instrument cannot be classified as equity. The exception for
settlement in case of liquidation (see 4.3.2 above) does not apply here as the regulator
is likely to invoke the resolution tool well before liq
uidation occurs. Also IFRIC 2
specifies that local law and regulations in effect at the classification date together with
the terms contained in the instrument’s documentation constitute the terms and
conditions of the instrument. [IFRIC 2.BC10]. However, in the FICE DP (see 12 below), the
IASB noted that IFRIC 2 was developed for a very specific fact pattern and that they do
not intend to apply the analysis in IFRIC 2 more broadly.31
The main conclusion to be drawn from examples such as these is that the provisions of
IAS 32, which were originally drafted in the mid-1990s to deal with ‘traditional’
convertible instruments, are not always adequate for dealing with the increasingly
complex range of instruments available in the financial markets now. However as
discussed in Section 12 below in June 2018 the IASB issued the FICE DP which
endeavours to address many of these issues.
6.6.4
Foreign currency convertible bond
If an entity issues a bond in a currency other than its functional currency, the
conversion option will not meet the definition of equity in IAS 32, even if the bond is
convertible into a fixed number of shares. This is because a fixed amount of foreign
currency (a currency different to the functional currency of the bond) is not a fixed
amount of cash (see 5.2.3 above). A foreign currency convertible bond is therefore
classified as a financial liability under IAS 32, and then measured under the
3560 Chapter 43
requirements of IFRS 9. An equity conversion option embedded in a financial liability
is not considered by IFRS 9 to be clearly and closely related to the host contract, and
should be accounted for as a separate derivative financial instrument measured at fair
value through profit or loss.
6.6.4.A
Instrument issued by foreign subsidiary convertible into equity of parent
The Interpretations Committee’s conclusion that (other than in the context of certain
rights issues – see 5.2.3.A above) 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
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 703
