[et_pb_section admin_label=”Header – All Pages” global_module=”1221″ transparent_background=”off” background_color=”#1e73be” allow_player_pause=”off” inner_shadow=”off” parallax=”off” parallax_method=”off” padding_mobile=”off” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” make_equal=”off” use_custom_gutter=”off” gutter_width=”3″ custom_padding=”||0px|”][et_pb_row global_parent=”1221″ admin_label=”row”][et_pb_column type=”4_4″][et_pb_post_title global_parent=”1221″ admin_label=”Post Title” title=”on” meta=”off” author=”on” date=”on” categories=”on” comments=”on” featured_image=”off” featured_placement=”below” parallax_effect=”on” parallax_method=”on” text_orientation=”left” text_color=”light” text_background=”off” text_bg_color=”rgba(255,255,255,0.9)” module_bg_color=”rgba(255,255,255,0)” title_all_caps=”off” use_border_color=”off” border_color=”#ffffff” border_style=”solid” title_font=”|on|||” title_font_size=”35″ custom_padding=”10px|||”] [/et_pb_post_title][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section admin_label=”Section” global_module=”1228″ fullwidth=”off” specialty=”off” transparent_background=”off” allow_player_pause=”off” inner_shadow=”off” parallax=”off” parallax_method=”off” custom_padding=”0px||0px|” padding_mobile=”on” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” make_equal=”off” use_custom_gutter=”off” gutter_width=”3″][et_pb_row global_parent=”1228″ admin_label=”Row” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” use_custom_gutter=”off” gutter_width=”3″ custom_padding=”0px||0px|” padding_mobile=”off” allow_player_pause=”off” parallax=”off” parallax_method=”off” make_equal=”off” parallax_1=”off” parallax_method_1=”off” column_padding_mobile=”on”][et_pb_column type=”4_4″][et_pb_text global_parent=”1228″ admin_label=”Text” background_layout=”light” text_orientation=”left” text_font_size=”14″ use_border_color=”off” border_color=”#ffffff” border_style=”solid”]
[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section admin_label=”Section” fullwidth=”off” specialty=”off”][et_pb_row admin_label=”Row”][et_pb_column type=”1_2″][et_pb_text admin_label=”Text” background_layout=”light” text_orientation=”center” text_font_size=”14″ use_border_color=”off” border_color=”#ffffff” border_style=”solid”] [button link=”http://www.frs102.com/members/premium-toolkit/” type=”big” color=”red”] Return to Main Index[/button] [/et_pb_text][/et_pb_column][et_pb_column type=”1_2″][et_pb_text admin_label=”Text” background_layout=”light” text_orientation=”center” text_font_size=”14″ use_border_color=”off” border_color=”#ffffff” border_style=”solid”] [button link=”http://frs102.com/members/premium-toolkit/section-22/” type=”big” color=”red”] Return to Section 22 Home[/button] [/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section admin_label=”Section” fullwidth=”off” specialty=”off” transparent_background=”off” allow_player_pause=”off” inner_shadow=”off” parallax=”off” parallax_method=”off” padding_mobile=”off” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” make_equal=”off” use_custom_gutter=”off” gutter_width=”3″][et_pb_row admin_label=”Row”][et_pb_column type=”4_4″][et_pb_text admin_label=”Main Body Text” background_layout=”light” text_orientation=”justified” use_border_color=”off” border_color=”#ffffff” border_style=”solid”]Convertible debt or similar compound financial instruments
Extract from FRS 102 – Section 22.13-22.15
22.13 On issuing convertible debt or similar compound financial instruments that contain both a liability and an equity component, an entity shall allocate the proceeds between the liability component and the equity component. To make the allocation, the entity shall first determine the amount of the liability component as the fair value of a similar liability that does not have a conversion feature or similar associated equity component. The entity shall allocate the residual amount as the equity component. Transaction costs shall be allocated between the debt component and the equity component on the basis of their relative fair values.
22.14 The entity shall not revise the allocation in a subsequent period.
22.15 In periods after the instruments were issued, the entity shall account for the liability component as a financial instrument in accordance with Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments Issues as appropriate. The appendix to this section illustrates the issuer’s accounting for convertible debt where the liability component is a basic financial instrument.
OmniPro comment
A compound instrument is an instrument that contains both an equity and debt component. Examples of compound instruments are:
- Mandatory redeemable preference shares/bonds at fixed amount at a fixed or future date with dividend payable at the discretion of the issuer. See example 9 above.
- Redeemable preference shares/bonds at holder’s option at some future date with dividend payable at the discretion of the issuer. See example 10 above.
- Preference shares/bonds convertible with a mandatory coupon redeemable at the option at the holder, into a fixed number of ordinary shares at any time up to maturity (see example 18 below).
See the example provided in Appendix to Section 22 in the FRS below which illustrates Section’s 22.14-22.15. This refers to bonds but the word bond can be replaced with preference shares:
Example 17: Accounting treatment for a compound financial instrument (instrument containing both a debt and equity component – bond with a fixed coupon and convertible at the option of the holder into a variable number of shares (Extracted from the appendix of Section 22 of FRS 102)
On 1 January 20X5 an entity issues 500 convertible bonds. The bonds are issued at par with a face value of CU100 per bond and are for a five-year term, with no transaction costs. The total proceeds from the issue are CU50,000. Interest is payable annually in arrears at an annual interest rate of 4 per cent. Each bond is convertible, at the holder’s discretion, into 25 ordinary shares at any time up to maturity. At the time the bonds are issued, the market interest rate for similar debt that does not have the conversion option is 6 per cent.
Here the liability component is the interest liability on the bond and the principal to be repaid. The equity component being the holder’s option to convert the bonds into a fixed number of equity shares.
When the instrument is issued, the liability component must be valued first, and the difference between the total proceeds on issue (which is the fair value of the instrument in its entirety) and the fair value of the liability component is assigned to the equity component. The fair value of the liability component is calculated by determining its present value using the discount rate of 6 per cent. The calculations and journal entries are illustrated below:
|
CU |
|
|
Proceeds from the bond issue (A) |
50.000 |
|
Present value of principal at the end of five years (see calculations in note 1 below) |
37,363 |
|
Present value of interest payable annually in arrears for five years (see calculations in note 1 below) |
8,425 |
|
Present value liability, which is the fair value of liability component (B) (see calculations in note 1 below) |
45,788 |
|
Residual, which is the fair value of the equity component (A) – (B) |
4,212 |
The issuer of the bonds makes the following journal entry at issue on 1 January 20X5:
|
CU |
CU |
|
|
Dr Cash |
50,000 |
|
|
Cr Financial Liability – Convertible Bond |
45,788 |
|
|
Cr Equity |
4,212 |
The CU4,212 represents a discount on issue of the bonds, so the entry could also be shown‘gross’:
|
CU |
CU |
|
|
Dr Cash |
50,000 |
|
|
Dr Financial Liability – Convertible Bond Discount |
4,212 |
|
|
Cr Financial Liability – Convertible Bond |
50,000 |
|
|
Cr Equity |
4,212 |
After issue, the issuer will amortise the bond discount according to the following table
|
(a) Interest payment CU |
(b) Total Interest expense = 6% x(e) CU |
Amortisation of bond discount =(b) – (a) CU |
(d) Bond discount = (d) – (c) CU |
(e) Net liability = 50,000 – (d) CU |
|
|
1/1/20X5 |
4,212 |
45,788 |
|||
|
31/12/20X5 |
2,000 |
2,747 |
747 |
3,465 |
46,535 |
|
31/12/20X6 |
2,000 |
2,792 |
792 |
2,673 |
47,327 |
|
31/12/20X7 |
2,000 |
2,840 |
840 |
1,833 |
48,167 |
|
31/12/20X8 |
2,000 |
2,890 |
890 |
943 |
49,057 |
|
31/12/20X9 |
2,000 |
2,943 |
943 |
0 |
50,000 |
|
Totals |
10,000 |
14,212 |
4,212 |
At the end of 20X5, the issuer would make the following journal entry:
|
CU |
CU |
|
|
Dr Interest Expense |
2,747 |
|
|
Cr Bond Discount |
747 |
|
|
Cr Cash |
2000 |
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Note 1: Calculations
Present value of principal of CU50,000 at 6 per cent
CU50,000/(1.06)^5 = CU37,363
The CU2,000 annual interest payments are an annuity: a cash flow stream with a limited
number (n) of periodic payments (C), receivable at dates 1 to n. To calculate the present value
of this annuity, future payments are discounted by the periodic rate of interest (i) using the following formula:
PV = C/i * [1 – 1/(1+i)n]
Therefore, the present value of the CU2,000 interest payments is (CU2,000/.06) * [1 – [(1/1.06)5] = CU8,425
This is equivalent to the sum of the present values of the five individual CU2,000 payments, as follows:
|
CU |
|
|
Present value of interest payment at 31 December 20X5 = 2,000/1.06 |
1,887 |
|
Present value of interest payment at 31 December 20X6 = 2,000/1.062 |
1,780 |
|
Present value of interest payment at 31 December 20X7 = 2000/1.063 |
1,679 |
|
Present value of interest payment at 31 December 20X8 = 2000/1.064 |
1,584 |
|
Present value of interest payment at 31 December 20X9 = 2000/1.065 |
1,495 |
|
Total |
8,425 |
Yet another way to calculate this is to use a table of present value of an ordinary annuity in
arrears, five periods, interest rate of 6 per cent per period. (Such tables are easily found on the Internet.) The present value factor is 4.2124. Multiplying this by the annuity payment of CU2,000 determines the present value of CU8,425.
Section 22 provides no guidance on how to account for the convertible option once it is exercised. In accordance with Section 10, one can look to IAS 32 for guidance in this regard. See the accounting treatment for same in example 19 below.
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Example 18: compound instrument where conversion is chosen
If we take example 17, and now assume at the end of 5 years, the convertible bond/preference shares are converted into 12,500 shares (i.e. CU50,000/CU100 per bond * 25 shares per bond). Assume the fair value of the shares issued at that date was CU4.50. The journal entries required to account for this is to:
|
CU |
CU |
|
|
Dr Liability |
50,000 |
|
|
Cr Equity |
50,000 |
NOTE: the original component stays in equity but can be transferred within equity. No gain or loss is ever recognised on conversion as no money changes hands.
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Example 19: compound instrument where conversion is chosen
If we take example 17 above and assume the conversion option was not taken. The journal required is:
|
CU |
CU |
|
|
Dr Liability |
50,000 |
|
|
Cr Bank |
50,000 |
The original equity component remains as equity. It may be transferred within equity for classification purposes.
Example 20: Accounting for transaction costs in acquiring a compound financial instrument
If we take example 17 above and assume transaction costs of CU1,000 were incurred. In accordance with Section 22 these transaction costs should be apportioned between the debt and equity element of the instrument in proportion to the split determined. For example this CU1,000 would be split as follows in example 17:
| Element of cost to be allocated to debt | CU1,000* CU45,788 = CU916 |
| CU50,000 |
| Element of cost to be allocated to equity | CU1,000* CU4,212 = CU84 |
| CU50,000 |
The CU916 is netted against the CU45,788 on initial recognition of the financial liability (CU44,872). The effective rate of interest is then obtained which accumulates the net CU44,872 to CU50,000 by the end of year 5. Through trial and error, the effective rate of interest is 6.466%
The same type of journals that were posted in example 17 would be posted here for the updated figures above.
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