Question

ABC Ltd is an Australian company issued $10 million convertible notes on 1 July 2019 that carry a nominal interest (coupon) rate of 5% per annum. They are redeemable on 30 June 2022 for cash or can be exchanged for ordinary shares in ABC Ltd on the basis of 20 shares for each $100 of note. The prevailing market interest rate for the notes without conversion options are 8%.

When preparing the draft financial statements for the year ended 30 June 2020, the directors are proposing to show the convertible note within equity in the statement of financial position, as they believe all the convertible note holders will choose the equity option when the convertible note is due for redemption. They further intend to charge a finance cost of $500,000 ($10 million x 5%) in the income statement for each year up to the date of redemption.

Required:

1. What is a compound or hybrid financial instrument? Please provide two examples of a compound or hybrid financial instrument.                                                                                                           

2. Briefly comment on the impact of the directors’ proposed treatment of the convertible notes on the financial statements and the acceptability of this treatment.                                                          

Using Australian Accounting Standard System (AASB)

Answer 1

A hybrid financial instrument is a financial instrument that comprises of both debt and equity component. Liability component means contractual arrangements to deliver cash whereas equity component means option to grant its holder the right to convert debt into a fixed number of equity shares.

Some of the examples of hybrid financial instruments are preference shares, convertible debentures, warrants etc. Preference shares are hybrid financial instruments because like debt, the holders of preference shares are entitled to fixed dividend and have a preferential right in respect of payment at the time of liquidation. Like equity shares, the payment of preference dividend is also made out of net profits after taxes. So, we can say that preference shares possess both the attributes of debt and equity. Similarly, convertible debentures are also considered as hybrid instruments because the holders of these debentures possess the option to convert them into equity on fulfilment of certain prescribed terms and conditions, which is in addition to the normal features of debentures.

As per new standard AASB 9 Financial Instruments, convertible debt or notes are treated as compound financial instrument, thus requiring the adoption of split-accounting approach, where accounting for debt component and conversion option are done separately. The initial recognition of debt component is done at fair value, which is then amortised over its life with the help of effective interest method. On the other hand, the conversion option can be treated as either equity or a financial liability. It depends on the fulfilment of "fixed for fixed" test criteria. A conversion option shall be classified as equity if it involves a fixed cash amount being exchanged for a fixed and pre-determined number of equity instruments. If not, it will be classified as financial liability.

Considering the above, it can be said that the proposed treatment of convertible notes by the directors is correct and therefore, convertible notes should be shown within equity in the balance sheet as they meet the "fixed for fixed" criterion i.e. option of converting notes into a fixed number of shares that is predetermined on the date of issue of notes.