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Compound financial instruments: example

A company issues a 3-year convertible bond at its par value of £1 million, which carries an interest coupon of 5%, payable annually in arrears.

»Ê¹ÚÌåÓýapp company must account separately for the debt and equity components.

»Ê¹ÚÌåÓýapp fair value of the instrument as a whole is £1 million, the proceeds of the debt issue.

In order to value the bond without the conversion option, the company needs to consider what the market rate of interest would be were it to issue a bond on similar terms but carrying no right to convert into shares. Suppose the market rate were 7%. »Ê¹ÚÌåÓýapp fair value without the conversion option will be the net present value of the cash flows receivable (interest receipts of £50,000 in years 1, 2 and 3, plus repayment of £1 million at the end), discounted at 7%. »Ê¹ÚÌåÓýapp fair value is £947,513.

»Ê¹ÚÌåÓýapp value of the equity component is the difference between the two figures, £52,487.

»Ê¹ÚÌåÓýapp equity element is not subsequently re-measured. »Ê¹ÚÌåÓýapp debt element could be measured either at FVTPL or at amortised cost, using the effective interest rate method (so any issue costs will be spread over the life of the instrument).

Suppose that, at maturity, the holder exercises the conversion option and the company issues 1 million £1 ordinary shares to the investor. »Ê¹ÚÌåÓýapp company derecognises the liability component (now amortised to £1m) and recognises it in equity. »Ê¹ÚÌåÓýapp £52,487 remains in equity, although it may be moved from one line within equity to another. »Ê¹ÚÌåÓýappre is no impact on the profit and loss account.