Accounting for corporate finance: liability and equity: compound financial instruments
Compound financial instruments are non-derivative financial instruments which have both a liability and an equity component. In accordance with the substance of the contractual arrangements, IAS 32 and Section 22 of FRS 102 both require the component parts to be accounted for and presented separately as financial liabilities, financial assets or equity instruments.
For example, a bond convertible by the holder into a fixed number of ordinary shares of the issuing company is a compound financial instrument. From the perspective of the issuer, 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 company). The economic effect of issuing such an instrument is substantially the same as issuing a debt instrument with detachable share purchase warrants. Accordingly, in all cases, the company presents the liability and equity components separately on its balance sheet. CFM21260 explains the mechanics of this.
Compound financial instruments should not be confused with hybrid financial instruments (see CFM25080).