Sometimes issued nonderivative financial instruments contain both liability and equity elements. In other words, one component of the instruments meets the definition of a financial liability and another component of the instrument meets the definition of an equity instrument. Such instruments are referred to as compound instruments.
A common form of compound financial instrument is a debt instrument with an embedded conversion option, such as a bond convertible into ordinary shares of the issuer, and without any other embedded derivative features.
Para. 28 of IAS 32 Financial Instruments : Presentation states that the issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets or equity instruments, as follows :
- 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 the 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.
- The equity instrument 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. This option has value on initial recognition even when it is out of the money.
How to recognize the initial carrying amounts of the liability and equity components of the compound instrument ?
As stated in the : IFRS – Practical Implementation Guide and Workbook, by Abbas Ali Mirza, Magnus Orrell and Graham J.Holt, to determine the initial carrying amounts of the liability and equity components, entities apply the so-called with-and-without method. The fair value of the instrument is determined first including the equity component. The fair value of the instrument as a whole generally equals the proceeds (consideration) received in issuing the instrument. The liability component is then measured separately without the equity component. The equity component is assigned the residual amount after deducting from the fair value of the compound instrument as a whole the amount separately determined for the liability component.
Entity A issues a bond with a principal amount of $100,000. The holder of the bond has the right to convert the bond into ordinary shares of Entity A. On issuance, Entity A receives proceeds of $100,000. By discounting the principal and interest cash flows of the bond using interest rates for similar bonds without an equity component, Entity A determines that the fair value of a similar bond without any equity component would have been $91,000. Therefore, the initial carrying amount of the liability component is $91,000. The initial carrying amount of the equity component is computed as the difference between the total proceeds (fair value) of $100,000 and the initial carrying amount of the liability component of $91,000. Thus the initial carrying amount of the equity component is $90,000. Entity A makes this journal entry :
Source of this article :
- IFRS – Practical Implementation Guide and Workbook, by Abbas Ali Mirza, Magnus Orrell and Graham J.Holt (2nd Edition)
- IAS 32 Financial Instruments : Presentation