Compound Financial Instruments

In this article, Steve Collings takes a look at the accounting treatment of compound financial instruments and looks at the provisions in IAS 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and Measurement.
Financial instruments are accounted for, having reference to three standards:
IAS 32 Financial Instruments: Presentation
IAS 39 Financial Instruments: Recognition and Measurement
IFRS 7 Financial Instruments: Disclosure
This article concerns IAS 32 and IAS 39 and we will also work through a comprehensive illustration on
how to account for a compound financial instrument. This article is outside the scope of the recently
issued IFRS 9 Financial Instruments which is planned to replace IAS 39.
The first thing to understand, however, is how to classify a financial asset and a financial liability.
Financial Assets
Financial assets contain four possible classifications within a set of financial statements:
Financial assets at fair value through profit or loss.
Held-to-maturity investments.
Loans and receivables.
Available-for-sale financial assets.
Financial assets at fair value through profit or loss are classified as such if the financial asset is:
Held-for-trading.
Was designated on initial recognition as one to be measured at fair value through profit or
loss.
Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments
that an entity intends and is able to hold to maturity and which do not meet the definition of loans or
receivables and upon initial recognition are not classified as assets at fair value through profit or loss as
available-for-sale.
Loans and receivables are non-derivative financial assets with fixed or determinable payments which
are not quoted in an active market, not held-for-trading and not designated on initial recognition as
assets at fair value through profit or loss or as available-for-sale.
Available-for-sale assets are non-derivative financial assets that do not meet any of the above criteria.
Financial Liabilities
Financial liabilities can be classified as:
Financial liabilities at fair value through profit or loss.
Other financial liabilities measured at amortised cost using the effective interest method.
Initial Measurement
Financial assets and liabilities should be measured at fair value. Fair value is the amount for which
an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms
length transaction.

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Illustration
On 1 April 2006, an 8% convertible loan with a nominal value of $600,000 was issued at par. It is
redeemable on 31 March 2010 also at par. Alternatively it may be converted into equity shares on the
basis of 100 new shares for each $200 worth of loan note.
An equivalent loan note without the conversion option would have carried interest at 10%. Interest of
$48,000 has already been paid and included as a finance cost.
Present value rates are as follows:
Present Values

End of Year

8%

10%

0.93

0.91

0.86

0.83

0.79

0.75

0.73

0.68

We are required to show the treatment of the above loan notes in the financial statements for the year
ended 31 March 2007.
We approach this by looking at the substance of the loan note initially. We can see that there is an
option to convert the loans into equity i.e. the loan note holders do not have to accept equity shares;
they could demand repayment in the form of cash. So is it a debt instrument or an equity instrument?
We look to the provisions of IAS 32 Financial Instruments: Presentation for the correct treatment.
Step 1
IAS 32 states that where there is an obligation to transfer economic benefits there should be a liability recognised. On the other hand, where there is not an obligation to transfer economic benefits, a
financial instrument should be recognised as equity.
In the facts above we have both equity and debt (i.e. a compound financial instrument). There is
an obligation to pay cash i.e. interest at 8% per annum and a redemption amount this is our debt.
The equity part of the transaction is the option to convert.
Now we have deciphered that the financial instrument is a mix of debt and equity, we need to consider how to recognise this in the statement of financial position and the statement of comprehensive
income.
Step 2
The question gives us present value rates and these need to be used to calculate the debt element of
the financial instrument so as to recognise the liability at its present value (note what is worth $100
now wont be worth $100 in 5 years time), hence discounting to present day values. But what rate do
we use? 8% - because thats the value of the interest payable on the loan note? No.
We have been told in the question that an equivalent loan note without the conversion option would
have carried interest at 10% - this is the value we use to discount the future cash flows. But what cash
flows?

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Going back to the question, we have been told that $48,000 has been paid as interest ($600,000 x 8%).
The loan note is redeemed on 31 March 2010, so we can calculate the debt element of the loan note
as follows:

8% Interest
Factor at a rate of
Present

($600,000 x 8%)
10%
Value
Year 1 2007
48,000
0.91
43,600
Year 2 2008
48,000
0.83
39,800
Year 3 2009
48,000
0.75
36,000

119,400
Year 4 * 2010
648,000
0.68
440,600
Amount to be recognised as a liability
560,000
Initial proceeds
(600,000)
Amount to be recognised as equity 40,000
* In year 4, the loan note is redeemed therefore $600,000 + $48,000 = $648,000.
Step 3
The next step is to look at the interest charge that we have already charged to the income statement.
The question states that $48,000 has been recognised in the statement of comprehensive income i.e.
$600,000 x 8% - but thats not the end of the answer!
The 8% loan note is simply the interest the loan note holders receive annually. We have to recognise
that an equivalent loan without the conversion option would carry interest at a higher rate, i.e. 10%, so
it is therefore necessary to reflect this. It would be inappropriate to show a liability discounted at 10%
with a finance cost of 8%!
Another way to look at it is we have discounted the present value of future interest payments and
redemption amount using discount factors of 10%, so the finance charge in the statement of comprehensive income must also be recognised at the same rate i.e. for the purpose of consistency, therefore
the finance cost charged to the income statement should also represent a rate of 10%. The additional
charge to be recognised in the income statement is calculated as:
Debt component of the financial instrument
Interest charge ($560,000 x 10%)

$560,000

$56,000

Already charged to the income statement

($48,000)

Additional charge required

$ 8,000

The entries required to reflect this are:

Statement of comprehensive income (finance costs)

CR

Liability

$8,000
($8,000)

Conclusion
Accounting for compound financial instruments can become somewhat tricky and it is therefore advisable to work through each step in a logical manner. We have looked at a typical scenario where a
financial instrument contains a mix of debt and equity, however question practise is the key to questions such as these.

Steve Collings FMAAT FCCA DipIFRS is the audit and technical director at LWA Ltd and a partner in AccountancyStudents. He is also the author of The Core Aspects of IFRS and IAS from which the illustration is extracted and also lectures on auditing and financial reporting issues.

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