A convertible bond instrument may have additional derivatives, such as a call or a put option. The accounting of such instruments can get very complex with regard to determining the values of and thereafter accounting for the host instrument, the equity element and the call option. The example in this article explains the concept in a very simplified manner.
EXAMPLE – MULTIPLE DERIVATIVES
Facts
• A Ltd. has issued Optionally Convertible Debentures (OCD) amounting to INR 300 crores to B Ltd. on the following terms:
• During the tenure of the OCDs, A Ltd. can call the OCD and redeem it with the stated IRR.
• The market rate for similar debt without conversion feature is 17% p.a.
• B Ltd. can also ask for conversion at any time before maturity based on the following formula:
- No. of equity shares = (Investment amount + applicable IRR) divided by (Face value of equity share; i.e.,
INR 10)
• If redemption or conversion doesn’t happen before maturity, then the OCDs will be redeemed mandatorily at maturity.
How is this instrument accounted for in the books of A Ltd. in the following two scenarios?
Scenario A – If B Ltd. opts for conversion before maturity at end of year 1.
Scenario B – B doesn’t opt for conversion and OCDs are redeemed at maturity.
Response
Let us first consider the relevant provisions under the Standards before we attempt to solve the problem.
Ind AS 32 Financial Instruments: Presentation
19. If an entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the obligation meets the definition of a financial liability, except …………….
29. An entity recognises separately the components of a financial instrument that (a) creates a financial liability of the entity and (b) grants an option to the holder of the instrument to convert it into an equity instrument of the entity. For example, a bond or similar instrument convertible by the holder into a fixed number of ordinary shares of the entity is a compound financial instrument. From the perspective of the entity, such an instrument comprises two components: a financial liability (a contractual arrangement to deliver cash or another financial asset) and an equity instrument (a call option granting the holder the right, for a specified period of time, to convert it into a fixed number of ordinary shares of the entity). The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants. Accordingly, in all cases, the entity presents the liability and equity components separately in its balance sheet.
32. Under the approach described in paragraph 31, the issuer of a bond convertible into ordinary shares first determines the carrying amount of the liability component by measuring the fair value of a similar liability (including any embedded non-equity derivative features) that does not have an associated equity component. The carrying amount of the equity instrument represented by the option to convert the instrument into ordinary shares is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.
Ind AS 109 Financial Instruments
B 4.3.5 (e) A call, put, or prepayment option embedded in a host debt contract or host insurance contract is not closely related to the host contract unless:
i. the option’s exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument or the carrying amount of the host insurance contract; or
ii. ………..
The assessment of whether the call or put option is closely related to the host debt contract is made before separating the equity element of a convertible debt instrument in accordance with Ind AS 32.
DAY 1 ACCOUNTING
Compound financial instrument (see paragraphs 19, 29 and 32 of Ind AS 32)
• The OCD issued by A Ltd. is a compound financial instrument. The host instrument will be classified as liability, since there is contractual obligation to pay cash toward interest (i.e., guaranteed IRR of 15% p.a.) and principal repayment that issuer A Ltd. cannot avoid. The equity conversion option is accounted as equity.
• The equity conversion option can’t be considered as closely related to the host instrument, because an equity conversion option is not a normal feature of a typical debt instrument, so it needs to be separated. The usual treatment for an instrument with these terms is to conclude that the ‘fixed for fixed’ criterion is met. This is because the number of shares is predetermined at the outset and the only variable is the passage of time. Accordingly, conversion option is classified as equity on Day 1.
• During the life of the host bond, expectations about early conversion should not be taken into account when estimating the cash flows used to apply the effective interest rate. The early conversion option is a characteristic of the equity component (the conversion option) and not of the host liability. The estimated cash flows used to apply the effective interest rate method are, therefore, the contractual cash flows based on the contractual final maturity of the host liability. The Effective Interest Rate (EIR) is 17% p.a.
Early call option to redeem OCD [see paragraph B4.3.5(e) of Ind AS 109]
• The call option’s exercise price is set at par value of OCD plus stated IRR till the date of exercise of call option. Therefore, at each exercise date the option’s exercise price is likely to be approximately equal to the amortised carrying amount of the OCDs plus the equity conversion option. Therefore, the call option is closely related to the host debt instrument. As a result, the call option is not separately accounted for but it remains part of the liability component. The assessment of whether the call option is closely related to the host debt contract is made before separating the equity element of a convertible debt instrument in accordance with Ind AS 32.
|
Date
|
Particulars
|
Amount
(rounded off in crores)
|
|
Day 1
|
Bank
|
300
|
|
|
|
To Equity (balancing figure representing residual interest)
|
|
20
|
|
|
To Debenture (future cash flows discounted at 17%)
|
|
280
|
|
|
(Initial recognition of the financial instrument
in the nature of a compound instrument comprising of elements of debt and
equity)
|
|
|
Subsequent accounting
|
Date
|
Particulars
|
Amount
(rounded off in crores)
|
|
End of Year 1
|
Interest on Debentures
|
48
|
|
|
|
To Debenture (classified under ‘Liability component of compound financial
instrument’)
|
|
48
|
|
|
(Interest recognised in P&L at EIR of 17%;
i.e. 280*17%)
|
|
|
Scenario A – If B Ltd. opts for conversion at end of Year 1
If B Ltd. opts for conversion before maturity – Since conversion was allowed under the original terms of instrument, the entity should determine the amortised cost of liability component using the original EIR till the conversion date. It will derecognise the liability component and recognise it as equity. There is no gain or loss on early conversion.
|
Date
|
Particulars
|
Amount
(rounded off in crores)
|
|
End of Year 1
|
Debenture [280+48]
|
328
|
|
|
|
To Equity share capital
|
|
328
|
|
|
(Conversion of OCD into equity shares of the
company)
|
|
|
Scenario B – If B doesn’t opt for conversion and OCDs are redeemed at maturity
|
Date
|
Particulars
|
Amount
(rounded off in crores)
|
|
Year 1-4
|
Interest on debentures (cumulative interest for 4 years)
|
245
|
|
|
|
To Debenture
|
|
245
|
|
|
(Interest recognised in P&L at EIR of 17%)
|
|
|
|
|
|
|
|
|
End of Year 4
|
Debenture [280+245]
|
525
|
|
|
|
To Bank
|
|
525
|
|
|
(Being debentures redeemed)
|
|
|
KEY TAKEAWAYS:
- In the case of a compound financial instrument, the instrument has to be separated for the liability and equity component;
- The instrument may have additional derivatives, such as a put or a call option. The accounting of such derivatives will depend upon whether those are closely related to the liability component. If the option is closely related to the liability component it is not separated from the liability component. On the other hand, if the option is not closely related to the liability component, it is separately accounted for and marked to market at each reporting date, till such time as it is finally settled;
- On settlement of the compound financial instrument, the equity element (INR 20) recognised initially, may be transferred to retained earnings.
