Accounting for corporate finance: liability and equity: example
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.
The company must account separately for the debt and equity components.
The 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%. The 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%. The fair value is £947,513.
The value of the equity component is the difference between the two figures, £52,487.
The equity element is not subsequently re-measured. The 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. The company derecognises the £947,513 liability component and recognises it in equity. The £52,487 remains in equity, although it may be moved from one line within equity to another. There is no impact on the profit and loss account.