Convertible notes - Are you accounting for these correctly (Part 7)?
In the current economic climate, we continue to see different types of convertible note arrangements, typically entered into by companies needing to offer attractive returns in order to obtain funds from lenders and investors.Over the past few months we have been looking at some practical aspects regarding accounting for convertible notes, including:
- An overview of the requirements (in the April 2018 edition of Accounting Alert)
- A detailed example of a convertible note classified as a compound financial instrument (in the May 2018 edition of Accounting Alert)
- A detailed example of a convertible note with an embedded derivative liability (in the mid-June edition of Accounting Alert)
- Common scenarios encountered in practice where conversion features either meet or fail equity classification (in the July 2018 edition of Accounting Alert)
- A detailed example of a convertible note converting into a variable number of shares based on the issuer’s share price at conversion date (in the August 2018 edition of Accounting Alert)
- A detailed example of a convertible note issued in a currency other than the issuer’s functional currency (in the September 2018 edition of Accounting Alert)
As noted in these previous articles, in order for a conversion feature to be classified as equity, the fixed for fixed test in IAS 32 Financial Instruments: Presentation (“IAS 32”) must be met (i.e. at initial recognition, the conversion feature gives the holder of the convertible note the right to convert into a fixed number of equity securities of the issuer).
| This month we look at a detailed example of a callable convertible note, i.e. a convertible note with a feature that allows the issuer to repay (call) the note early. |
Summary
Some convertible notes contain a call option which allows the issuer to repay the principal plus any outstanding accrued interest at any time during the life of the note. From the issuer’s perspective, this call feature is a derivative because future changes in interest rates could mean that the redemption amount of the loan is less than its fair value.However, this derivative is not accounted for as a separate embedded derivative because the repayment price is equal to the amortised cost of the host debt instrument and therefore, under one of the exceptions in IAS 39 Financial Instruments: Recognition and Measurement, it is considered to be closely related to the debt host contract. Therefore no separate accounting is required for the call option.
Example: Callable convertible note (at option of issuer)
ABC Limited issues a convertible note with a face value of $10,000, maturing three years from its date of issue.The note pays a 10% annual coupon and, on maturity, the holder has an option either to receive cash of $10,000 or 10,000 ABC Limited shares.
The value of a similar bond without the equity conversion option feature is $9,500.
The note also has a call feature which allows ABC Limited to repay the principal plus any outstanding accrued interest at any time during the life of the note. The additional call feature is determined to be worth $100 to ABC Limited.
Step one
Starting with the box on the top left hand side of the flowchart above, we consider whether there is a contractual obligation to pay cash that the issuer cannot avoid. The answer is yes, because ABC Limited must pay the annual 10% cash coupon, and it could also be required to repay the $10,000 capital amount at the end of three years if the holder chooses not to exercise the conversion option.Step two
Step two is to consider whether paragraphs 16A to 16D of IAS 32 apply. When an issuer has an obligation to repurchase financial instruments, in certain circumstances paragraphs 16A to 16D of IAS 32 include exceptions to the usual principles for classifying financial instruments as financial liabilities. In some cases, such instruments could be classified as equity, despite having an unavoidable obligation to pay out cash. However, this exception does not typically apply to convertible instruments and is not applicable in this example.Step three
Continuing down the right hand side of the above flow chart, we then consider whether the instrument has any characteristics that are similar to equity. The answer is yes, because the instrument contains an option to be converted into equity instruments, but the question of whether the conversion feature meets the criteria to be classified as equity is dealt with separately in step four below.The host debt component will be classified as a financial liability because ABC Limited has an unavoidable obligation to pay cash, and on a standalone basis there is no feature in the host debt contract that is similar to equity.
Step four
The conversion feature is then assessed on a standalone basis using the above flowchart. Starting with the box at the top left hand side of the diagram:- There is no contractual obligation to pay cash that the issuer (ABC Limited) cannot avoid. The equity conversion feature can only be settled through the issue of equity shares, otherwise it will simply expire unexercised
- There is no obligation to issue a variable number of shares. If exercised, the option will result in the issue of 10,000 ABC Limited shares, and
- The book value of the convertible note is not variable, i.e. the convertible note is not denominated in a foreign currency.
In addition, the note also has a call feature which allows ABC Limited to repay the principal plus any outstanding accrued interest at any time during the life of the note. However, as discussed above, this derivative is not accounted for as a separate embedded derivative (because it is considered to be closely related to the debt host contract).
This means that the note as a whole contains the following liability and equity components:
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ABC Limited recognises the following journal entry at initial recognition to record the callable convertible note transaction:
