Sometimes issued non-derivative financial instruments contain both liability and equity elements. In other words, one component of the instrument 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. The approach to accounting for compound instruments is to apply split accounting, that is, to present the liability and equity elements separately. Through this post I discuss split accounting for compund instruments, adapted from IAS 32, enriched with case examples and practical insights to ensure that you’re able to understand this topic easily.

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IAS 32 provides this principle: The issuer of a nonderivative 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.

 

Example:

To illustrate, a bond that is convertible into a fixed number of ordinary shares of the issuer is a compound instrument. From the perspective of the issuer, a convertible bond has two components:

[1]. An obligation to pay interest and principal payments on the bond as long as it is not converted. This component meets the definition of a financial liability, because the issuer has an obligation to pay cash.

[2]. A sold (written) call option that grants the holder the right to convert the bond into a fixed number of ordinary shares of the entity. This component meets the definition of an equity instrument.

 

Practical Insight

Instruments that from the issuer’s perspective have both liability and equity elements are from the holder’s perspective often financial assets that contain embedded derivatives under IAS 39. However, split accounting under IAS 32 is different from embedded derivatives accounting under IAS 39, because under IAS 39 an embedded derivative is separated and accounted for as a financial asset or financial liability at fair value, while under IAS 32, an embedded derivative that meets the definition of an equity instrument is classified and presented as own equity.

 

 
Determining The Initial Carrying Amounts Of Liability And Equity Components

By requiring split accounting for the components of compound instruments, IAS 32 ensures that financial liabilities and equity instruments are accounted for in a consistent manner irrespective of whether they are transacted together in a single, compound instrument (e.g., a convertible bond) or transacted separately as two freestanding contracts (i.e., a bond and an issued share warrant).

To determine the initial carrying amounts of the liability and equity components, entities
apply the so-called “with-and-without
method:

Step-1: The fair value of the instrument is determined first including the equity component.

Step-2: The fair value of the instrument as a whole generally equals the proceeds (consideration) received in issuing the instrument.

Step-3: The liability component is then measured separately without the equity component.

Step-4: 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.

That is: Fair value of compound instrument – Fair value of liability component (= its initial carrying amount) = Initial carrying amount of equity component.

 

Note: The opposite is not permitted; that is, it is not appropriate to determine the fair value of the equity component first and then allocate the residual to the liability component. The sum of the initially recognized carrying amounts of the liability and equity components always equals the amount that would have been assigned to the instrument as a whole.

 
Case Example-1:

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 $9,000And, Entity A makes this journal entry:

[Debit]. Cash = $100,000
[Credit]. Financial liability = $91,000
[Credit]. Equity = $9,000

 

The subsequent accounting for the liability component is governed by IAS 39. For example: if the liability component is measured at amortized cost, the difference between the initial carrying amount of the liability component ($91,000 in the example) and the principal amount at maturity ($100,000 in the example) is amortized to profit or loss as an adjustment of interest expense in accordance with the effective interest method. This has the effect of increasing interest expense as compared with the stated interest rate on the bond.

Note: The accounting for the equity component is outside the scope of IAS 39. Equity is not remeasured subsequent to initial recognitionClassification of the liability and equity components of a convertible debt instrument is not revised as a result of a change in the likelihood that the equity conversion option will be exercised.

 

 

Case Example-2 [Accounting for Issued Convertible Debt Instruments]

On October 31, 20X8, Entity A issues convertible bonds with a maturity of five years. The issue is for a total of 1,000 convertible bonds. Each bond has a par value of $100,000, a stated interest rate is 5% per year, and is convertible into 5,000 ordinary shares of Entity A. The convertible bonds are issued at par. The per-share price for an Entity A share is $15. Quotes for similar bonds issued by Entity A without a conversion option (i.e., bonds with similar principal and interest cash flows) suggest that they can be sold for $90,000.

 

Required:

(a) Indicate how “Entity A” should account for the compound instrument on initial recognition; and
(b) Determine whether the effective interest rate will be higher, lower, or equal to 5%.

 

Solutions:

Entity A should separate the liability and equity components of the convertible bonds using the withand- without method. First, it should determine the fair value of the liability element. This is equal to $90,000 because similar bonds without an equity component sell for $90,000. Accordingly, the initial carrying amount of the liability component is $90,000. Second, it should determine the initial carrying amount of the equity component. This is equal to the difference between the total proceeds received from the bond of $100,000 and the initially allocated amount to the liability component of $90,000.

Therefore, the carrying amount of the equity component is $10,000. The journal entry is:

[Debit]. Cash = $100,000
[Credit]. Financial liability = $90,000
[Credit]. Equity = $10,000

 

The effective interest rate is higher than 5% because it includes amortization of the difference between the initial carrying amount of the liability component of $90,000 and the principal amount of the liability of $100,000 [The effective interest rate is 7.47%].

 

 

Financial Instruments That Will or May Be Settled in Own Equity

Sometimes entities enter into contracts that will or may be settled in equity instruments issued by the entity [“own equity”]. For example: a contract may specify that the entity is required to deliver as many of the entity’s own equity instruments as are equal in value to $100,000 on a future date. In that case, the number of shares that will be delivered will vary based on changes in the share price. If the share price increases, fewer shares will be delivered. If the share price decreases, more shares will be delivered.

Alternatively, a contract may specify that the entity is required to deliver as many of the entity’s own equity instruments as are equal in value to the value of 100 ounces of gold on a future date. In that case, the number of shares that will be delivered will vary based on changes in both the share price and the gold price. If the share price increases, fewer shares will be delivered. If the share price decreases, more shares will be delivered. If the gold price increases, more shares will be delivered. If the gold price decreases, fewer shares will be delivered.

Contracts that will or may be settled in the entity’s own equity instruments are classified as equity instruments of the entity if they:

  • Are nonderivative contracts and will be settled by issuance of a fixed number of the entity’s own equity instruments; or
  • Are derivative contracts and will be settled by the exchange of a fixed number of the entity’s own equity instruments and a fixed amount of cash.

 

Because such instruments are classified as own equity, any consideration received for such an instrument is added directly to equity and any consideration paid is deducted directly from equity. Changes in fair value of such instruments are not recognized.

 

Examples of instruments that will or may be settled in own equity and are classified as equity instruments of the entity are:

[1]. An issued (written) call option or warrant that gives the holder the right to purchase a fixed number of equity instruments of the entity (e.g., 1,000 shares) for a fixed price (e.g., $100). If the proceeds from issuing the call option is $9,000, the entity makes this journal entry:

[Debit]. Cash = $9,000
[Credit]. Equity = $9,000

 

[2]. A purchased call option that gives the entity the right to repurchase a fixed number of its own issued equity instruments (e.g., 1,000 shares) for a fixed price (e.g., $100). If the price for purchasing the call option is $9,000, the entity makes this journal entry:

[Debit]. Equity = $9,000
[Credit]. Cash = $9,000

 

[3]. A forward contract to sell a fixed number of equity instruments (e.g., 1,000 shares) of the entity to another entity for a fixed exercise price at a future date (e.g., $100). If the forward is entered into at a zero fair value, no journal entry is required until settlement of the transaction. If, however, there is any variability in the amount of cash or own equity instruments that will be received or delivered under such a contract (e.g., based on the share price, the price of gold, or some other variable), the contract is a financial asset or financial liability, as applicable. Examples of instruments that are classified as financial liabilities are:

  • A contract that requires the entity to deliver as many of the entity’s own equity instruments as are equal in value to $100,000 on a future date
  • A contract that requires the entity to deliver as many of the entity’s own equity instruments as are equal in value to the value of 100 ounces of gold on a future date
  • A contract that requires the entity to deliver a fixed number of the entity’s own equity instruments in return for an amount of cash calculated to equal the value of 100 ounces of gold on a future date.

 

If a financial instrument requires the issuer to repurchase its own issued equity instruments for cash or other financial assets, there is a financial liability for the present value of the repurchase price (redemption amount). The liability is recognized by reclassifying the amount of the liability from equity. Subsequently, the liability is accounted for under IAS 39. If it is classified as a financial liability measured at amortized cost, the difference between the repurchase price and the present value of the repurchase price is amortized to profit or loss as an adjustment to interest expense using the effective interest rate method.

 

Case Example-3

On January 1, 20X9, Entity A enters into a forward contract that requires the entity to repurchase 1,000 shares for $60,000 on December 31, 20X9. No consideration is paid or received at inception of the contract. The market interest rate is 10%, such that the present value of the payment is $54,545 [= 60,000/(1 + 10%)]. Therefore, the entity makes this journal entry on initial recognition to recognize its liability for the repurchase price:

[Debit]. Equity = $54,545
[Credit]. Liability = $54,545

 

On December 31, 20X9, Entity A makes this entry to recognize the amortization in accordance with the effective interest method:

[Debit]. Interest expense = $6,565
[Credit]. Liability = $6,565

 

Finally, on December 31, 20X9, Entity A settles the forward contract and makes this journal entry:

[Debit]. Liability = $60,000
[Credit]. Cash = $60,000

 

Note: If a derivative financial instrument gives one party a choice over how it is settled, it is a financial asset or financial liability unless all of the settlement alternatives would result in it being an equity instrument.

 

One example of a contract that would be classified as a financial liability because it provides for a choice of settlement is a written call option on own equity that the entity can decide to settle either:

  • By issuing a fixed number of own equity instruments in return for a fixed amount of cash; or
  • Net in cash in an amount equal to the difference between (1) the value of a fixed number of own equity instruments and (2) a fixed amount.

 

Such a financial liability would be accounted for as a derivative at fair value. If the contract had not included a net settlement alternative [(b) above], it would have been classified as an equity instrument because it would not have contained any variability in the amount of cash or the number of equity instruments that would have been exchanged.