Many of our readers requested to share actual calculation and the process to bifurcate any convertible bonds between Equity & Liability and its related Journal Entry.
Let’s refer some relevant guidance/ reference related to these kind of convertible bonds and its related calculation as mentioned in accounting standards –
Ind-As 32- Financial Instruments- Presentation
Para -28– The issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets or equity instruments in accordance with paragraph 15.
Para -29– An entity recognises separately the components of a financial instrument that (a) creates a financial liability of the entity and (b) grants an option to the holder of the instrument to convert it into an equity instrument of the entity. For example, a bond or similar instrument convertible by the holder into a fixed number of ordinary shares of the entity is a compound financial instrument. From the perspective of the entity, such an instrument comprises two components: a financial liability (a contractual arrangement to deliver cash or another financial asset) and an equity instrument (a call option granting the holder the right, for a specified period of time, to convert it into a fixed number of ordinary shares of the entity). The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants. Accordingly, in all cases, the entity presents the liability and equity components separately in its balance sheet.
Para -15– The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument.
Para -31– Ind AS deals with the measurement of financial assets and financial liabilities. Equity instruments are instruments that evidence a residual interest in the assets of an entity after deducting all of its liabilities. Therefore, when the initial carrying amount of a compound financial instrument is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. The value of any derivative features (such as a call option) embedded in the compound financial instrument other than the equity component (such as an equity conversion option) is included in the liability component. The sum of the carrying amounts assigned to the liability and equity components on initial recognition is always equal to the fair value that would be ascribed to the instrument as a whole. No gain or loss arises from initially recognising the components of the instrument separately.
Let’s take a hypothetical example to understand the whole process and its Journal Entries-
Entity A has issued bonds worth of INR 100 Million when its fair value also was at its issue price. Interest rate will be payable by 4% p.a. at the end of each year for next 3 years. Holder of the bond has option to convert the same into fixed number of Equity shares till the end of 3 years period. Same kind of Bond but without conversion option is available at the interest rate of 8% p.a. Since the conversion into Equity is fixed price for fixed amount, hence it will be classified as Equity component which is to be splitted from this Bond.The summary and calculation to split the liability and equity will be as followed-
|Terms of Bonds|
|Value of bonds||100 millions|
|Rate of interest||4% annual|
|Duration of Bond||3 years|
|Conversion option||Anytime at fixed no. of shares|
|Market rate intt.
|8%||(without conversion option)|
|Classification||Equity component within Bond|
As per para 31 of Ind-As-32 the calculation will be done as below-
|Cash Flow Streams|
|Intt. @ 4% p.a.||1||4,000,000||3,703,704|
|Intt. @ 4% p.a.||2||4,000,000||3,429,355|
|Intt. @ 4% p.a.||3||4,000,000||3,175,329|
Journal Entries of the above will be as below –
|To Equity (component)||Cr.||10,308,388|
|(To record Bond with conversion option)|
Let’s take an additional scenario where issuer has a CALL option in which the Bond can be called back any time by the Issuer –
|Additional Features (Issuer’s Call option)|
|Value of Issuer Call Option||2,000,000||(Given value)|
|(Using Option Pricing Modal)|
|Value of Bond Issue||A||100,000,000||(Given value)|
|Equivalent Bond Fair Value||92,000,000||(Given Value)|
|(no call option/ conversion)|
|Fair value of Bond||B||90,000,000||(to deduct call value)|
|(with issuer call option)|
|Equity Value (residual)||A- B||10,000,000|
|difference of A & B|
The call option value has been derived by using Option Pricing Modal and the same will be deducted from the fair value of the Bond which is otherwise available without these call option. Because Call Value will reduce fair value of the Bond as the Issuer will always use its CALL OPTION whenever it is Unfavorable to the Holder. Below are the Journal entries for the same –
|To Equity (component)||Cr.||10,000,000|
|(To record Bond with conversion option)|
Readers will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as an Independent IFRS Advisor & Corporate Trainer. He can be reached via email at email@example.com or Whatsapp +91-9634706933)