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Compound financial instruments: example

A company issues a 3-year convertible bond at its par value of 拢1 million, which carries an interest coupon of 5%, payable annually in arrears.

The company must account separately for the debt and equity components.

The fair value of the instrument as a whole is 拢1 million, the proceeds of the debt issue.

In order to value the bond without the conversion option, the company needs to consider what the market rate of interest would be were it to issue a bond on similar terms but carrying no right to convert into shares. Suppose the market rate were 7%. The fair value without the conversion option will be the net present value of the cash flows receivable (interest receipts of 拢50,000 in years 1, 2 and 3, plus repayment of 拢1 million at the end), discounted at 7%. The fair value is 拢947,513.

The value of the equity component is the difference between the two figures, 拢52,487.

The equity element is not subsequently re-measured. The debt element could be measured either at FVTPL or at amortised cost, using the effective interest rate method (so any issue costs will be spread over the life of the instrument).

Suppose that, at maturity, the holder exercises the conversion option and the company issues 1 million 拢1 ordinary shares to the investor. The company derecognises the liability component (now amortised to 拢1m) and recognises it in equity. The 拢52,487 remains in equity, although it may be moved from one line within equity to another. There is no impact on the profit and loss account.