Ias 32 - compound financial instruments :Presentation

1. 1
IAS 32 FINANCIAL INSTRUMENTS: PRESENTATION
A compound financial instrument is a financial instrument that has the characteristics of
both an equity and liability (debt). An example would be a bond that can be converted
into shares. It doesn't matter whether the bondholders will ultimately opt for conversion.
As long as there is the option to convert into shares, the financial instrument would carry
an equity component.
IAS 32 Financial Instruments: Presentation requires compound financial instruments to
be split into their component parts, i.e.:
 a financial liability (the debt component); and
 an equity instrument (the option to convert into shares).
These must be shown separately in the financial statements.
To illustrate this requirement, let's say Entity A issued a $10 million convertible bond at
par. On initial recognition, the bond should be measured at the fair value of
consideration received, i.e. $10 million. However, the financial instrument needs to be
split into its debt and equity components. The double entry would therefore be:
Dr Cash $10 million
Cr Liability - Bond ?
Cr Equity ?
Splitting the financial instrument
The financial instrument is split by first determining the debt component. The debt
component is calculated as the present value of future cash flows of the instrument
discounted using the current interest rate for similar bonds without the conversion rights.
The equity component is then calculated by deducting the debt component from the
proceeds of the instrument.
Any transaction costs are then apportioned to the debt and equity components in
proportion to the allocation of proceeds.

2. 2
Illustration 1 (without transaction costs)
On 1 January 20X4, Enzer issued a $50 million three-year convertible bond at par with
the following terms:
 There were no issue costs
 The coupon rate is 10%, payable annually in arrears on 31 December
 The bond is redeemable at par on 1 January 20X7
 Bondholders may opt for conversion. The terms of the conversion are two 25 cents
shares for every $1 owed to each bondholder on 1 January 20X7
 Bonds issued by similar companies without any conversion rights currently bear interest
at 15%.
Required:
How should the bond be accounted for by Enzer assuming:
(a) The bondholders opt for conversion
(b) The bondholders opt for cash payment
Solution
This is a compound financial instrument. Enzer is required to present the debt and
equity components of the instrument separately in the financial statements.
The debt component is calculated as the present value of future cash flows of the bond
discounted using the current interest rate for similar bonds without the conversion rights.
The debt and equity components of the instrument are determined as follows:
Year ended Cash
flow
Discount
factor
Present
value
@ 15%
$000 $000
31 December
20X4
5,000 1/1.15 4,348
31 December
20X5
5,000 1/1.152
3,781
31 December
20X6
55,000 1/1.153
36,163
Debt component 44,292
Proceeds of 50,000

3. 3
issue
Equity
component
5,708
Therefore, on initial recognition, Enzer should account for the instrument as follows:
$000
Dr Cash 50,000
Cr Liability - Bond 44,292
Cr Equity 5,708
Subsequent to initial recognition, the debt component is a normal liability and should be
measured at amortised cost as follows:
End of Year Opening Effective Cash Closing
balance interest
at 15%
paid balance
$000 $000 $000 $000
31 December
20X4
44,292 6,644 (5,000) 45,936
31 December
20X5
45,936 6,890 (5,000) 47,826
31 December
20X6
47,826 7,174 (5,000) 50,000
The carrying amounts at 1 January 20X7 are:
$000
Equity 5,708
Liability - Bond 50,000
55,708
On conversion
Number of shares issued ($50 million x 2 shares) = 100 million shares.
The value of shares issued is 100 million shares x 25c = $25 million.
The remaining $30,708,000 should be classified as share premium.
The following entries should be made:

4. 4
$000
Dr Equity 5,708
Dr Liability - Bond 50,000
Cr Share capital 25,000
Cr Share premium 30,708
Note: Both the equity and liability components are extinguished by the issue of shares.
On redemption
The liability of $50 million will be extinguished by cash payment. The equity component
will remain within equity, as a non-distributable reserve.
The following entries should be made:
$000
Dr Liability - Loan 50,000
Cr Cash 50,000
Illustration 2 (without transaction costs)
On 1 January 20X4, Enzer issued a $50 million three-year convertible bond at par with
the following terms:
 Issue costs amounted to $500,000
 The coupon rate is 10%, payable annually in arrears on 31 December
 The bond is redeemable at par on 1 January 20X7
 Bondholders may opt for conversion. The terms of the conversion are two 25 cents
shares for every $1 owed to each bondholder on 1 January 20X7
 Bonds issued by similar companies without any conversion rights currently bear interest
at 15%
 The impact of the issue costs is to increase the effective interest rate to 15.425%
Required:
How should the bond be accounted for by Enzer assuming:
(a) The bondholders opt for conversion
(b) The bondholders opt for cash payment
Solution
Enzer is required to present the debt and equity components of the instrument
separately in the financial statements.

5. 5
The debt component is calculated as the present value of future cash flows of the bond
discounted using the current interest rate for similar bonds without the conversion rights.
The debt and equity components of the instrument are determined as follows:
Year ended Cash
flow
Discount
factor
Present
value
@ 15%
$000 $000
31 December
20X4
5,000 1/1.15 4,348
31 December
20X5
5,000 1/1.152
3,781
31 December
20X6
55,000 1/1.153
36,163
Debt component 44,292
Proceeds of
issue
50,000
Equity
component
5,708
The issue costs would be allocated to the debt and equity components in proportion to
the allocation of proceeds.
Debt Equity Total
$000 $000 $000
Proceeds 44,292 5,708 50,000
Issue costs (443) (57) (500)
43,849 5,651 49,500
Therefore, on initial recognition, Enzer should account for the instrument as follows:
$000
Dr Cash 50,000
Cr Liability - Bond 44,292
Cr Equity 5,708
$000
Dr Liability - Bond 443
Dr Equity 57
Cr Cash 500
Subsequent to initial recognition, the debt component is a normal liability and should be
measured at amortized cost as follows:

6. 6
End of Year Opening Effective Cash Closing
balance interest
at
15.425%
paid balance
$000 $000 $000 $000
31 December
20X4
43,849 6,764 (5,000) 45,613
31 December
20X5
45,613 7,036 (5,000) 47,649
31 December
20X6
47,649 7,351 (5,000) 50,000
The carrying amounts at 1 January 20X7 are:
$000
Equity 5,651
Liability - Bond 50,000
55,651
On conversion
Number of shares issued ($50 million x 2 shares) = 100 million shares.
The value of shares issued is 100 million shares x 25c = $25 million.
The remaining $30,651,000 should be classified as share premium.
The following entries should be made:
$000
Dr Equity 5,651
Dr Liability - Bond 50,000
Cr Share capital 25,000
Cr Share premium 30,651
Note: Both the equity and liability components are extinguished by the issue of shares.
On redemption
The liability of $50 million will be extinguished by cash payment. The equity component
will remain within equity, as a non-distributable reserve.

7. 7
The following entries should be made:
$000
Dr Liability - Loan 50,000
Cr Cash 50,000
Important points to note:
Note that if the bondholders opt for conversion, both liability and equity will be
extinguished as the equity component will be converted into shares. However, if the
bondholders opt for cash redemption, then only the liability component will be
extinguished because there are no shares being issued, hence the equity component
will not be converted. In this case, the equity component will remain as a non-
distributable reserve, i.e. it cannot be used as a reserve from which dividends are paid.