In: Accounting
When an entity issues a financial instrument, it has to determine its classification either as debt or as equity. The result of the classification can have a significant effect on the entity’s reported results and financial position. Discuss the implications for a business if a substance approach is used for the reporting of convertible bonds. Explain what is meant by the term split accounting when applied to convertible bonds.
The classification of debt and equity in an entity’s financial statement depends on various factors. Many financial instruments have both features which can lead to inconsistency of reporting.
IAS 32 clarifies the definition of financial assets, financial liabilities and equity. In doing so, it helps to eliminate any uncertainties when accounting for these financial instruments. The objective of IAS 32, Presentation is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and liabilities. The classification of a financial instrument by the issuer as either debt or equity can have a significant impact on the entity’s gearing ratio, reported earnings, and debt covenants. Equity classification can avoid such impact but may be perceived negatively if it is seen as diluting existing equity interests. The distinction between debt and equity is also relevant where an entity issues financial instruments to raise funds to settle a business combination using cash or as part consideration in a business combination.
The classification of the financial instrument as either a liability or as equity is based on the principle of substance over form. Two exceptions from this principle are certain puttable instruments meeting specific criteria and certain obligations arising on liquidation. Some instruments have been structured with the intention of achieving particular tax, accounting or regulatory outcomes, with the effect that their substance can be difficult to evaluate.
Some instruments are structured to contain elements of both a liability and equity in a single instrument. Such instruments – for example, bonds that are convertible into a fixed number of equity shares and carry interest – are accounted for as separate liability and equity components. 'Split accounting' is used to measure the liability and the equity components upon initial recognition of the instrument. This method allocates the fair value of the consideration for the compound instrument into its liability and equity components. The fair value of the consideration in respect of the liability component is measured at the fair value of a similar liability that does not have any associated equity conversion option. The equity component is assigned the residual amount.
SPLIT ACCOUNTING, under IAS 39, provides that if certain conditions
are met the 'embedded derivative' in a 'hybrid (combined) financial
instrument' (i.e, a financial instrument which includes a
non-derivative 'host contract' as well as an embedded derivative)
must be accounted for separately from the 'host contract'.
issuing company must separately identify the liability and equity components of convertible bonds and treat them accordingly in the financial statements. Initially, the liability component is calculated by discounting the future cash flows of the bonds (interest and principle) at the rate of a similar debt instrument without the conversion option. The value of the equity component is the difference between the present value of the liability component of the convertible bond (as mentioned above) and the total proceeds from the issue of bonds. This is known as the residual approach to calculation of equity component which assumes that value of the share option is equal to the difference between the total issue proceeds of the convertible bonds and the present value of future cash flows using the interest rate of a similar debt instrument without the option to convert into shares.
Subsequently, Interest is charged to the income statement based on the effective interest rate, which is usually higher than the nominal rate, to reflect the true opportunity cost of the financial liability.
Upon maturity of the convertible bonds, the accounting treatment depends on whether the conversion option is exercised or lapsed. If the conversion option is not exercised, the company will have to pay the principal amount of the convertible bonds. Therefore, the outstanding liability may be simply de-recognized. If however, the conversion option is exercised, the company will have to issue shares to the bondholders. Hence, both liability and equity components of the convertible bonds will need to be de-recognized and replaced by share capital reserves as they are treated as consideration for the new shares issue.