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Ias 32 - compound financial instruments

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Ias 32 - compound financial instruments :Presentation

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Ias 32 - compound financial instruments

  1. 1. 1 IAS 32 FINANCIAL INSTRUMENTS: PRESENTATION A compound financial instrument is a financial instrument that has the characteristics of both an equity and liability (debt). An example would be a bond that can be converted into shares. It doesn't matter whether the bondholders will ultimately opt for conversion. As long as there is the option to convert into shares, the financial instrument would carry an equity component. IAS 32 Financial Instruments: Presentation requires compound financial instruments to be split into their component parts, i.e.:  a financial liability (the debt component); and  an equity instrument (the option to convert into shares). These must be shown separately in the financial statements. To illustrate this requirement, let's say Entity A issued a $10 million convertible bond at par. On initial recognition, the bond should be measured at the fair value of consideration received, i.e. $10 million. However, the financial instrument needs to be split into its debt and equity components. The double entry would therefore be: Dr Cash $10 million Cr Liability - Bond ? Cr Equity ? Splitting the financial instrument The financial instrument is split by first determining the debt component. The debt component is calculated as the present value of future cash flows of the instrument discounted using the current interest rate for similar bonds without the conversion rights. The equity component is then calculated by deducting the debt component from the proceeds of the instrument. Any transaction costs are then apportioned to the debt and equity components in proportion to the allocation of proceeds.
  2. 2. 2 Illustration 1 (without transaction costs) On 1 January 20X4, Enzer issued a $50 million three-year convertible bond at par with the following terms:  There were no issue costs  The coupon rate is 10%, payable annually in arrears on 31 December  The bond is redeemable at par on 1 January 20X7  Bondholders may opt for conversion. The terms of the conversion are two 25 cents shares for every $1 owed to each bondholder on 1 January 20X7  Bonds issued by similar companies without any conversion rights currently bear interest at 15%. Required: How should the bond be accounted for by Enzer assuming: (a) The bondholders opt for conversion (b) The bondholders opt for cash payment Solution This is a compound financial instrument. Enzer is required to present the debt and equity components of the instrument separately in the financial statements. The debt component is calculated as the present value of future cash flows of the bond discounted using the current interest rate for similar bonds without the conversion rights. The debt and equity components of the instrument are determined as follows: Year ended Cash flow Discount factor Present value @ 15% $000 $000 31 December 20X4 5,000 1/1.15 4,348 31 December 20X5 5,000 1/1.152 3,781 31 December 20X6 55,000 1/1.153 36,163 Debt component 44,292 Proceeds of 50,000
  3. 3. 3 issue Equity component 5,708 Therefore, on initial recognition, Enzer should account for the instrument as follows: $000 Dr Cash 50,000 Cr Liability - Bond 44,292 Cr Equity 5,708 Subsequent to initial recognition, the debt component is a normal liability and should be measured at amortised cost as follows: End of Year Opening Effective Cash Closing balance interest at 15% paid balance $000 $000 $000 $000 31 December 20X4 44,292 6,644 (5,000) 45,936 31 December 20X5 45,936 6,890 (5,000) 47,826 31 December 20X6 47,826 7,174 (5,000) 50,000 The carrying amounts at 1 January 20X7 are: $000 Equity 5,708 Liability - Bond 50,000 55,708 On conversion Number of shares issued ($50 million x 2 shares) = 100 million shares. The value of shares issued is 100 million shares x 25c = $25 million. The remaining $30,708,000 should be classified as share premium. The following entries should be made:
  4. 4. 4 $000 Dr Equity 5,708 Dr Liability - Bond 50,000 Cr Share capital 25,000 Cr Share premium 30,708 Note: Both the equity and liability components are extinguished by the issue of shares. On redemption The liability of $50 million will be extinguished by cash payment. The equity component will remain within equity, as a non-distributable reserve. The following entries should be made: $000 Dr Liability - Loan 50,000 Cr Cash 50,000 Illustration 2 (without transaction costs) On 1 January 20X4, Enzer issued a $50 million three-year convertible bond at par with the following terms:  Issue costs amounted to $500,000  The coupon rate is 10%, payable annually in arrears on 31 December  The bond is redeemable at par on 1 January 20X7  Bondholders may opt for conversion. The terms of the conversion are two 25 cents shares for every $1 owed to each bondholder on 1 January 20X7  Bonds issued by similar companies without any conversion rights currently bear interest at 15%  The impact of the issue costs is to increase the effective interest rate to 15.425% Required: How should the bond be accounted for by Enzer assuming: (a) The bondholders opt for conversion (b) The bondholders opt for cash payment Solution Enzer is required to present the debt and equity components of the instrument separately in the financial statements.
  5. 5. 5 The debt component is calculated as the present value of future cash flows of the bond discounted using the current interest rate for similar bonds without the conversion rights. The debt and equity components of the instrument are determined as follows: Year ended Cash flow Discount factor Present value @ 15% $000 $000 31 December 20X4 5,000 1/1.15 4,348 31 December 20X5 5,000 1/1.152 3,781 31 December 20X6 55,000 1/1.153 36,163 Debt component 44,292 Proceeds of issue 50,000 Equity component 5,708 The issue costs would be allocated to the debt and equity components in proportion to the allocation of proceeds. Debt Equity Total $000 $000 $000 Proceeds 44,292 5,708 50,000 Issue costs (443) (57) (500) 43,849 5,651 49,500 Therefore, on initial recognition, Enzer should account for the instrument as follows: $000 Dr Cash 50,000 Cr Liability - Bond 44,292 Cr Equity 5,708 $000 Dr Liability - Bond 443 Dr Equity 57 Cr Cash 500 Subsequent to initial recognition, the debt component is a normal liability and should be measured at amortized cost as follows:
  6. 6. 6 End of Year Opening Effective Cash Closing balance interest at 15.425% paid balance $000 $000 $000 $000 31 December 20X4 43,849 6,764 (5,000) 45,613 31 December 20X5 45,613 7,036 (5,000) 47,649 31 December 20X6 47,649 7,351 (5,000) 50,000 The carrying amounts at 1 January 20X7 are: $000 Equity 5,651 Liability - Bond 50,000 55,651 On conversion Number of shares issued ($50 million x 2 shares) = 100 million shares. The value of shares issued is 100 million shares x 25c = $25 million. The remaining $30,651,000 should be classified as share premium. The following entries should be made: $000 Dr Equity 5,651 Dr Liability - Bond 50,000 Cr Share capital 25,000 Cr Share premium 30,651 Note: Both the equity and liability components are extinguished by the issue of shares. On redemption The liability of $50 million will be extinguished by cash payment. The equity component will remain within equity, as a non-distributable reserve.
  7. 7. 7 The following entries should be made: $000 Dr Liability - Loan 50,000 Cr Cash 50,000 Important points to note: Note that if the bondholders opt for conversion, both liability and equity will be extinguished as the equity component will be converted into shares. However, if the bondholders opt for cash redemption, then only the liability component will be extinguished because there are no shares being issued, hence the equity component will not be converted. In this case, the equity component will remain as a non- distributable reserve, i.e. it cannot be used as a reserve from which dividends are paid.

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