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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Accounting for corporate finance: Old UK GAAP excluding FRS 26: lenders: accrual accounting: convertibles

The following guidance covers Old UK GAAP (applied before 2015) where FRS 26 was not applied.

Accounting for convertible securities

A convertible security is a loan that may be converted into another asset. The conversion can be at the option of the lender or the borrower and the terms of conversion can vary considerably. As a convertible security is a loan and a right to convert combined, the accounting for it follows the two component parts.

Example 1

Lampon plc makes a £100m loan to Sparty Ltd bearing interest at 8% fixed. The loan can either be repaid (redeemed) or at the option of the lender the loan can be converted into 10,000,000 ordinary shares of Sparty Ltd. The option can be exercised at any point after 5 years. Lampon plc accounts for the convertible as a £100m 8% fixed rate loan, and the income receivable as interest in the profit and loss account. If the lender exercises the right to convert then the loan is reclassified as an investment in shares with no change to its book value. The bookkeeping in Lampon plc upon conversion would be:

  Debit Credit
     
  £M £M
Investment in Sparty Ltd 100  
Loan to Sparty Ltd   100

Example 2

Lampon plc makes a £100m loan to Minnie plc bearing interest at LIBOR plus 2%. The loan can either be redeemed or at the option of the lender the loan can be converted at the 5 year point into ordinary shares in Minnie plc with a market value of £110m. Lampon plc accounts for the convertible as though it was a loan for £100m bearing variable interest of LIBOR plus 2% with a premium on conversion of £10m after 5 years. Thus by the end of year 5, the carrying value of the loan in Lampon plc’s balance sheet will be £110M.

This example differs from example 1 because Lampon plc acquires shares in Minnie plc with a stated market value (£110M) and not as is example 1 a set number of shares. Furthermore, because the market value of the shares which Lampon plc will receive (£110M) exceeds the amount it would receive should the loan be redeemed (£100M) it has been assumed that the option to convert will be exercised.

Example 3

Lampon plc makes a £100m interest free loan to Ziggy plc. After 5 years the borrower can either redeem the loan at £120m or issue 10,000,000 ordinary shares in Ziggy plc. Lampon plc accounts for the convertible as though it was a zero coupon bond with a premium of £20m after 5 years. If the share price of Ziggy plc falls below £12 then the recoverability of the £120m at redemption should be assessed as it is likely that the borrower will exercise the option to convert the loan to shares instead of redeeming it.