How to Account for Compound Financial Instruments (IAS 32) with Example in Excel
What is a compound financial instrument?Standard IAS 32 defines compound financial instrument as a non-derivative financial instrument that, from the issuer’s perspective, contains both liability and an equity component.
ie. that the issuer of this instrument cannot simply show it purely as a liability or purely as an equity because this instrument contains the both.
For Example: If a bond convertible into a fixed number of shares (the bond holder can get paid either by cash at maturity or exchange this bond for some fixed number of issuer’s shares);
The Two components would be;
Liability is issuer’s obligation to pay interest or coupon and, to redeem the bond in cash at maturity potentially.
Equity is the holder’s call option for issuer’s shares (ie. holder can chose to get fixed amount of shares and not getting fixed amount of cash).
Accounting treatment in issuer’s financial statementsSteps to be followed on initial recognition;
Step 1: Identify the various components of the compound financial instrument.That’s obvious. The issuer must clearly identify what the liability element is and what the equity element is.
Step 2: Determine the fair value of the compound financial instrument as a whole.Basically this shouldn’t be any problem, because if the transaction happens under market conditions, then the fair value of the instrument as a whole equals to cash received in return for the instrument.
Step 3: Determine the fair value of the liability component.The fair value of the liability component can be determined at fair value of a similar liability that does NOT have any associated equity conversion feature. So for example, the fair value of the liability component of the convertible bond equals to fair value of the bond with the same parameters (maturity, coupon rate, etc.) but without the option to convert into issuer’s shares.
Step 4: Determine the fair value of the equity component.The equity component is determined simply as the fair value of the compound financial instrument as a whole (step 2) less the fair value of the liability component (step 3).
So the Double Entries would be;
Dr Cash 750,000 To Liability- Convertible Bonds 657,746 Equity- Convertible Bonds92,254
How to Account for Compound Financial Instruments (IAS 32) with Example in Excel Reviewed by Azreen Mohamed on Tuesday, October 21, 2014 Rating: