Convertible Instrument which is not a compounded financial instrument

It is very intuitive to consider all the convertible instrument as a compound financial instrument which contains both a liability and an equity component. However, in this article we will cover the convertible instruments which has equity conversion option,but do not meet the criteria of a compounded financial instrument and it’s accounting treatment under Ind AS.

For an instrument to qualify as a compounded financial instrument, the convertible instrument should have the following basic characteristics [para 29 of Ind AS 32]:

1. Creates a financial liability for issuer (i.e. create a contractual obligation to pay cash or another financial asset that the issuer cannot avoid);

And

2. Grants an option to convert the instrument it into a fixed number of ordinary shares of the entity (popularly known as fixed for fixed criteria).

For example:One convertible bond with face value of INR 100 and coupon rate of 8% for the period of 5 years will be compulsorily converted into 10 equity share having face value of INR 10 at the end of the term. The market rate of bond with similar term but without conversion option is 10%.

The said financial instrument is compounded financial instrument since it has both the component mentioned in point 1 and 2 above i.e. liability component in the form of contractual payment of coupon and conversion option which will convert the bond into a fixed number of ordinary shares of the entity.

However, not always all the convertible instrument will be compounded financial instrument.Following are few scenarios where convertible instrument which will not be a compounded financial instrument:

1. Instruments convertible into variable number of ordinary shares based on market price existed on conversion date:

Since, conversion option does not meet the fixed for fixed criteria and are convertible in variable number of ordinary shares,it fails the equity classification and thus, the instrument will be classified as financial liability in entirety. The conversion option which fails the equity classification is derivative as per Ind AS 109 as it meets all the three criteria of derivative mentioned below:

(a) its value changes in response to the change in a specified financial instrument price, (i.e. market value of underlying equity share)

(b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors (difference between bond with conversion option and bond without conversion option)

(c) it is settled at a future date.

Conversion option is embedded derivative which needs to accounted separately since the economic characteristics and risks of the conversion option are not closely related to the economic characteristics and risks of the host financial liabilities, as the fair value of conversion option depends upon the market price of underlying equity share which is not the case for host financial liabilities [para 4.3.3 of Ind AS 109]

Accordingly, at the initial recognition the host financial liabilities will be at fair value and subsequently will be carried at amortised cost. The conversion option i.e. embedded derivative will be initially recognised at fair value and subsequently will be carried at fair value through profit and loss.

Initial fair value of host liability will be derived by reducing the fair value of embedded derivative from total value of hybrid instrument. The process to find out fair value of liability component is different from compounded financial instrument where first fair value of financial liabilities component will be identified, and residual value will be considered as equity component.

Determination of fair value of embedded derivative is challenging due to its unique characteristic such as its non-standardization and unavailability of market quotes, hence the fair value will be determined using appropriate valuation method such as binomial option pricing model.

Further para 4.3.7 of Ind AS 109 provides an alternative method to derive the fair value of embedded derivative.It states that if an issuer is unable to reliably measure the fair value of an embedded derivative on the basis of its terms and conditions, the fair value of the embedded derivative is the difference between the fair value of the hybrid contract and the fair value of the host liability.

Illustration:

Entity has issued the compulsory convertible debenture (CCD) on following terms:

Face value	INR 100
Coupon rate	8.00%
Coupon payment term	Annually
Conversion terms	At any time after date of allotment at the option of holder or conversion at the end of 5 years from the date of allotment whichever is earlier
Conversion ratio	Face value of CCD Market price on conversion date

The conversion option fair value as per valuation method at issue date is INR 20.

Analysis:

Since, entity cannot avoid cash payment obligation (i.e. coupon payment) and considering that the conversion option does not meet the fixed for fixed criteria,it fails the equity classification.Thus,it is not a compounded financial instrument and accordingly, will be classified as financial liability in entirety.

However, the conversion option become embedded derivative since it has a distinct economic characteristics and risks which are not closely related to the economic characteristics and risks of the host financial liabilities due to whichthe host financial liabilityand embedded derivative will be recognised separately.

For instrument with embedded derivative liabilities, the embedded derivative liability is determined first, and the residual value is assigned to the host liability. Therefore, the host liability is initially recognised at INR 80 being the residual value from deducting the fair value of the derivative liability from the transaction price (i.e. INR 100 less INR 20).

The host liability will be recognised initially at fair value and subsequently carried at amortised cost using effective interest rate:

Year	Opening balance	Interest expense @ 13.80% (EIR method)	Outflow (interest exp @ 8% coupon)	Closing balance
1	80.00	11.04	8.00	83.04
2	83.04	11.46	8.00	86.49
3	86.49	11.93	8.00	90.43
4	90.43	12.48	8.00	94.91
5	94.91	13.09	8.00	100.00

The fair value of the conversion option would have to be determined at each reporting date and the fair value changes would be recognised in profit or loss. The following table show the effect on profit or loss assuming the following fair values at each year end:

Year end	Fair value (assumption)	Profit/(loss) in the statement of profit and loss
Initial recognition	20.00	—-
1	30.00	(10.00)
2	10.00	20.00
3	0.00	10.00
4	60.00	(60.00)
End of term	0.00*	60.00
		20.00

*Till the end of term if conversion option is not exercised its fair value will become zero and net impact will be charged to statement of profit & loss.

2. Convertible instrument having a call option which allow the issuer at any time during the term of instrument to convert into fixed number of ordinary shares.

The instrument can be viewed as an equity instrument, because the issuer has the ability to convert the instrument into a fixed number of its own shares at any time. The issuer, therefore, has the ability to avoid making a cash payment or settling the instrument in a variable number of its own shares. Any feature that might have been considered to be an embedded derivative would not meet the definition of a derivative on a stand-alone basis, given the ability to avoid payment. Hence, the issuer’s conversion and redemption option could not be separated and thus, the entire instrument would be classified as equity.

Furthermore,until instrument converted into ordinary shares the coupon payments will be recognised when they are actually paid and will relate to the equity component (since issuer can avoid the payment by early conversion of instrument) and accordingly, are recognised as a distribution of profit or loss

Illustration:

Entity has issued the compulsory convertible debenture (CCD) having following terms:

Face value	INR 100
Coupon rate	8.00%
Coupon payment term	Annually
Conversion terms	At any time after date of allotment at the option of issuer or conversion at the end of 5 years from the date of allotment whichever is earlier
Conversion ratio	1 CCD into 1 equity share of INR 10 each at the premium of INR 90

Analysis:

As evident above, entity has the ability to convert CCD into fixed number of equity share (avoid conversion into variable number of shares) and also avoid making a cash payment. Hence, any feature considered to be an embedded derivative would not meet the definition of a derivative on a stand-alone basis, given the ability to avoid payment. Thus,the entire instrument would be classified as equity.

Further, any payment of coupon before the conversion of CCD into equity share will be recognised when they are actually paid and thus, will relate to the equity component and accordingly, are recognised as a distribution of profit or loss

Please note the above treatment is only for accounting purpose and the treatment for income tax and other regulatory aspect required to be evaluated separately.