Compound financial instruments became very common way of raising cash by many companies, but their shareholders don’t like them that much. Why?
Because many compound financial instruments contain the option to convert into shares. Just imagine you purchased convertible bond that gives you the right to take issuer’s share instead of redemption in cash. If the issuer is some solid and quickly growing company, then this option is nice for you because you can gain lots of money in the future from increasing share’s price.
But you can imagine that current issuer’s shareholders don’t like your option—because this option can reduce their share in the company. It’s logical—because if new shares are issued and current shareholders don’t get them, then their proportional share goes down.
In order to clearly show the potential risk of reducing shareholder’s share in the company, standard IAS 32 Financial Instruments: Presentation clearly sets the rules for accounting and presentation of the compound financial instruments.
What is a compound financial instrument?
Standard IAS 32 defines compound financial instrument as a non-derivative financial instrument that, from the issuer’s perspective, contains both liability and an equity component.
It means that the issuer of such an instrument cannot simply show it purely as a liability or purely as an equity, because this instrument contains a little bit of both. Wanna examples? Here they are:
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Example 1: A bond convertible into a fixed number of issuer’s shares
When the bond is convertible into shares, it means that the bond holder can get paid either by cash at maturity or exchange this bond for some fixed number of issuer’s shares. It is a compound financial instrument because it contains 2 elements:
- a liability = issuer’s obligation to pay interest or coupon and POTENTIALLY, to redeem the bond in cash at maturity (or a conventional loan); and
- an equity = the holder’s call option for issuer’s shares (or in other words, holder can chose to get fixed amount of shares instead of fixed amount of cash).
Example 2: A preference share redeemable at issuer’s discretion with mandatorily paid dividends
If an issuer issuers such a share, he must pay dividends each year (or in line with terms of the share), but the issuer can also chose whether and when he redeems the share. Again, this is a compound financial instrument with 2 elements:
- a liability = issuer’s obligation to pay dividends; and
- an equity = the issuer’s call option for own shares (or in other words, issuer can chose to pay fixed amount of cash for fixed amount of shares).
How to account for compound financial instruments
Before outlining the accounting treatment let me stress that the accounting treatment in issuer’s financial statements significantly differs from accounting treatment in holder’s financial statements.
Issuer is someone who creates the compound financial instrument—we can equally call him “borrower” because he raises money by issuing compound financial instrument.
As opposite, holder is someone who acquires compound financial instrument and we can call him “lender”.
Accounting treatment in issuer’s financial statements
IAS 32 requires so-called “split accounting” for compound financial instruments. It means that the issuer must perform the following steps on initial recognition:
Step 1: Identify the various components of the compound financial instrument.
That’s obvious. The issuer must clearly identify what the liability element is and what the equity element is—just refer to examples above.
Step 2: Determine the fair value of the compound financial instrument as a whole.
Basically this shouldn’t be any problem, because if the transaction happens under market conditions, then the fair value of the instrument as a whole equals to cash received in return for the instrument.
Step 3: Determine the fair value of the liability component.
The fair value of the liability component can be determined at fair value of a similar liability that does NOT have any associated equity conversion feature. So for example, the fair value of the liability component of the convertible bond equals to fair value of the bond with the same parameters (maturity, coupon rate, etc.) but without the option to convert into issuer’s shares.
Step 4: Determine the fair value of the equity component.
The equity component is determined simply as the fair value of the compound financial instrument as a whole (step 2) less the fair value of the liability component (step 3).
So as a result, the accounting entry on initial recognition is as follows:
Now, if issuer incurs certain costs associated with the issue of compound financial instruments, these should be allocated to the liability and equity components proportionally.
Subsequently, after initial recognition, the equity component remains untouched—so it is NOT remeasured and stays where it is until the final settlement.
On the other hand, liability component is accounted for in line with IFRS 9—either by application of effective interest rate method or at fair value through profit or loss—that depends on the classification of the liability.
Accounting treatment in holder’s financial statements
This is really a different cup of tea. When holder buys a compound financial instrument, for example—convertible bond, it also has 2 components:
- A derivative financial asset—which is the call option for issuer’s share in this example, and
- A receivable towards issuer—which is the loan provided to issuer by acquiring his bond.
So the holder has 2 assets in fact. In this case, a derivative financial asset shall be measured at first (at fair value of the option) and the fair value of the receivable shall be calculated as a residual. However, that’s not the main topic of this article—I just wanted you to know and to realize this 🙂
Compound financial instruments vs. Hybrid financial instruments
To finish this article, let me explain what the difference between “compound” and “hybrid” financial instruments is because I noted that many people interchange these 2 terms—yet they mean totally different things:
- Compound financial instrument: that’s the NON-DERIVATIVE financial instrument containing both equity and liability components.
- Hybrid financial instrument or hybrid contract is the one containing embedded derivative.
While accounting for compound financial instrument is arranged by IAS 32 Financial Instruments: Presentation, rules for identification and accounting for embedded derivatives are arranged by IFRS 9 Financial Instruments.
So just be careful to look for the right thing 🙂
And now, enjoy the video with example on accounting for convertible bond in the issuer’s financial statements. This short video is a clip from my long course on financial instruments, so I hope you’ll like it:
As someone deeply entrenched in the realm of financial instruments and accounting standards, I understand the complexities and nuances surrounding compound financial instruments. My experience in the field has exposed me to a myriad of scenarios, allowing me to navigate through the intricate details and implications associated with these instruments.
Now, let's delve into the concepts touched upon in the article:
Compound Financial Instruments: Compound financial instruments have become a prevalent method for companies to raise capital. However, the hesitancy of shareholders towards them stems from the fact that many of these instruments contain conversion options into shares. This conversion option poses a potential threat to existing shareholders' ownership stakes, as the issuance of new shares can dilute their holdings.
IAS 32 Financial Instruments: Presentation: The International Accounting Standard (IAS) 32 sets the rules for accounting and presenting compound financial instruments. It defines a compound financial instrument as a non-derivative financial instrument that, from the issuer’s perspective, comprises both a liability and an equity component.
Examples of Compound Financial Instruments: The article provides two examples to illustrate compound financial instruments:
- Convertible Bond: This instrument allows the bondholder to choose between receiving cash at maturity or exchanging the bond for a fixed number of issuer's shares.
- Preference Share: This share is redeemable at the issuer's discretion with mandatorily paid dividends, containing both a liability (obligation to pay dividends) and an equity (issuer's call option for own shares) component.
Accounting Treatment for Compound Financial Instruments: The accounting treatment differs between the issuer and the holder. For the issuer, IAS 32 mandates "split accounting," involving the identification of components, determination of fair values, and subsequent allocation of costs. The equity component remains unchanged, while the liability component is accounted for in line with IFRS 9.
Accounting Treatment for Holder's Financial Statements: Holders of compound financial instruments, such as convertible bonds, have both a derivative financial asset (call option for issuer's share) and a receivable towards the issuer (loan). The derivative financial asset is measured at fair value, while the fair value of the receivable is calculated as a residual.
Compound Financial Instruments vs. Hybrid Financial Instruments: It's crucial to distinguish between compound and hybrid financial instruments. Compound financial instruments are non-derivative instruments containing both equity and liability components. On the other hand, hybrid financial instruments involve embedded derivatives, and their identification and accounting are governed by IFRS 9.
In conclusion, understanding the intricacies of compound financial instruments requires a comprehensive grasp of accounting standards, such as IAS 32 and IFRS 9, to ensure accurate and transparent financial reporting.