This article discusses the classification of a compound financial instrument in its simplest form from the issuer’s perspective.
IAS 32 Financial Instruments: Presentation provides guidance on the accounting requirements for the classification of financial instruments. The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial asset, a financial liability or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial asset, a financial liability and an equity instrument.
For example, a bond convertible by the holder into a fixed number of ordinary shares of the issuing entity is a compound financial instrument. From the perspective of the issuer, the convertible bond is a type of compound financial instrument with characteristics of both a liability (the liability host contract) and an equity component (the conversion feature). The split is made at issuance and not revised as a result of a change in the likelihood that the conversion option will be exercised.
The issuer of a bond convertible into ordinary shares first determines the carrying amount of the liability component by measuring the fair value of a similar liability (including any embedded non-equity derivative features) that does not have an associated equity component. The carrying amount of the equity instrument represented by the option to convert the instrument into ordinary shares is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.
| Equity component= | Fair Value of the Bond – | Fair Value of the financial liability |
The value of any derivative features (such as call option) embedded in the compound financial instrument other than the equity component (such as an equity conversion option) is included in the liability component.
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 Day One Recognition.
IAS 32 requires the issuer of such a financial instrument to present the liability component and the equity component separately in the statement of financial position, as follows:
(a) The issuer’s obligation to make scheduled payments of interest and principal is a financial liability that exists as long as the instrument is not converted. On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at that time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option.
(b) The equity instrument is an embedded option to convert the liability into equity of the issuer. This option has value on initial recognition even when it is out of the money.
This article only discusses the convertible bond in its simplest form from the issuer’s perspective. For hybrid financial instruments (which involves derivative liabilities) or convertible bonds held by an investor (classified as financial assets under IFRS 9), you are advised to consult your experts on relevant requirements and applications.
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