ACYFARP: Compound Financial Instruments

Compound Financial Instrument

A financial instrument that contains both a liability and an equity element from the perspective of the issuer.

Examples include:

a. Bonds with share warrants

b. Convertible bonds

Financial Instrument

Is contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial Instrument

It has the following characteristics:

a. There must be a contract

b. There must be at least two parties to the contract

c. The contract shall give rise to a financial asset of one party and financial liability or equity instrument of another party.

Accounting for Compound Financial Instruments

Compound Financial Instruments shall be accounted for separately. The consideration received from the issuance of such instrument shall be allocated between the liability and equity components using the residual approach.

Residual Approach in Accounting for Compound Financial Instruments

Under this approach, the fair value of the liability must be determined first. The residual amount (or the amount left after deducting the fair value of the liability component from the total consideration received) is assigned or allocated to the equity component.

Residual Approach in Accounting for Compound Financial Instruments

Amount Allocated to the Equity Component = Total Consideration - Fair Value of Liability Component

Share Warrants

Represent the right to acquire shares of the issuing entity at a specified price at some future time.

Bonds with Share Warrants

The issue price or total consideration received must be allocated as follows:

a. To the bonds (liability component) - the market value of the bonds ex-warrants (or bonds without the warrants).

b. To the warrants (equity component) - residual amount.

True

(True or False) If the market value of bonds is unknown, the amount to be assigned to the bonds is the present value of future cash payments (principal and interest) using the effective rate for similar bonds without the warrants as of the issuance date.

Share Warrants Outstanding

Is classified as an equity item under share premium.

Share Premium - Share Warrants Outstanding

Total Cash Received from Exercising the Share Warrants + Share Warrants Exercised - Total Par Value of Shares Issued

Convertible Bonds

Bonds that can be exchanged into shares or other securities of the issuing entity within a specified period of time. The issue price or total consideration received must be allocated as follows:

a. To the bonds (liability component) - the market value of the bonds ex-warrants (or bonds without the warrants).

b. To the warrants (equity component) - residual amount.

Bond Conversion Privilege Outstanding

Is classified as an equity item under share premium.

Actual Conversion of Bonds

Procedures:

a. Update the carrying amount of the bonds by updating the amortization of the premium or discount to the date of conversion.

b. The face amount of the bonds shall be cancelled together with the related unamortized discount or premium.

If only a portion of the bonds were converted, the unamortized discount or premium shall be cancelled proportionately.

True

(True or False) Any cost incurred in connection with the bond conversion shall be charged to the share premium arising from bond conversion or debit to "share issue cost".

True

(True or False) No gain or loss conversion shall be recognized on the conversion of the bonds.

Share Premium from Conversion of Bonds

Bonds Converted + Related Premium on Bonds - Related Discount on Bonds + Bond Conversion Privilege Exercised - Total Par Value of Shares Issued

Settlement of Convertible Bonds - At Maturity Date

The bond retirement price is simply equal to the face value of the bonds. Any remaining balance in the bond conversion privilege outstanding account will be transferred to share premium.

Settlement of Convertible Bonds - Prior to Maturity Date

The bond retirement price is allocated to the liability and equity component using the residual approach. The retirement price is allocated to the liability component will be compared to the carrying amount of the bonds to determine the gain or loss on retirement.

Loss on Bond Retirement

Retirement Price > Carrying Amount of the Bonds on the Retirement

Gain on Bond Retirement

Retirement Price < Carrying Amount of the Bonds on the Retirement

Increase in Share Capital as a Result of Bond Conversion

Number of Bonds to be Converted x Number of Shares per Bond Conversion x Par Value of Share

True

(True or False) In solving for the share premium from the issuance of shares as a result of the bond conversion, bond conversion cost shall be deducted from the bonds to be converted, and the unamortized premium or discount.

True

(True or False) In solving for the gain or loss on the extinguishment of convertible bonds payable, it is essential to deduct the amount payable for the compound financial instrument from its equity component. It shall be erroneous to get the gain or loss by comparing the carrying amount of the liability component with the gross amount payable (without first deducting the equity component). To simply put, to get the gain or loss on extinguishment, the amount that shall be indicated in the financial instrument shall now only pertain to the liability component.