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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.
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. 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. That is
Fair value of compound instrument
– Fair value of liability component (= its initial carrying amount)
= Initial carrying amount of equity component
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.
Example
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 $9,000. Entity A makes this journal entry:
Cash 100,000
Financial liability 91,000
Equity 9,000
The subsequent accounting for the liability component is governed by IAS 39. For instance, 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.
The accounting for the equity component is outside the scope of IAS 39. Equity is not remeasured subsequent to initial recognition.
Classification 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.
This case illustrates the accounting for issued convertible debt instruments.
Facts
CASE STUDY 3
On October 31, 20X5, 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