Loan relationships: ‘hybrid’ securities with embedded derivatives: accounting treatment: examples of bifurcation
Examples of how the holder and issuer treat a bifurcated security
Holder of a convertible bond
A Ltd subscribes for a 3 year bond issued by X Ltd at its par £1m, carrying interest at 5 per cent. The bond redeems for cash £1million or, at A Ltd’s option, may be converted into 10,000 ordinary £1 shares in X Ltd.
A Ltd is required to account separately for the loan and the option. At acquisition, it considers the fair value of the security as a whole to be its issue price, £1m. A Ltd values the conversion option using an option pricing model. The initial fair value of the option is calculated by A Ltd to be £52,487. The initial value of the loan element is thus accounted for as the difference between £1m and £52,487 - that is, £947,513.
A Ltd accounts as if it had paid X Ltd £947,513 for the loan relationship and £52,487 for granting the conversion option. In effect, the loan is treated as purchased at a discount of £52,487.
Subsequently, A Ltd may account for the loan relationship on an amortised cost basis, for example if it classifies the convertible as loans and receivables, accruing the ‘implied discount’ of £52,487 over the term of the loan (CFM21640). But it must measure the derivative component at fair value at each balance sheet date.
If it is not possible for a fair value to be determined for the conversion option, A Ltd must derive the value by comparing the fair value of the loan element with the fair value of the whole instrument. This method can be used on initial recognition and subsequently.
But if A Ltd cannot value the derivative reliably even by this method, then it must account for the convertible as a whole as held for trading, measuring it at fair value and crediting or debiting fair value changes to profit and loss account.
Issuer of a convertible bond
The issuer, X Ltd, may also be required to account separately for the equity component - its obligation to issue its own shares if the conversion option is exercised. If so it will determine the value of the equity component as the difference in fair value between the instrument as a whole, and its financial liability.
This equity component is not subsequently revalued. So even if X Ltd initially values the equity component at £52,487 - the same value that A Ltd places on its embedded option - there will not be any subsequent parity between the balance sheets of issuer and holder, because different accounting rules apply.
Even initially, X Ltd may not arrive at exactly the same split as the holder, as it derives a fair value of the loan element (based upon market rates of interest it would pay for a plain loan instrument) and applies the residual (representing the conversion option) to equity. By comparison, A Ltd fair valued the conversion option and applied the residual to the loan. Additionally the issuer will apportion any direct issue costs in the same ratio. For convenience, assume that X Ltd arrived at the same split - £947,513 and £52,487 - and that its issue costs were £20,000. It apportions these rateably between the components: £18,950 and £1,050. The initial fair values of the loan and option obligations are then £928,563 and £51,437. These total £980,000, being X Ltd’s net proceeds of issue after issue costs.
Example of a bifurcated asset-linked security
The mechanics of ‘bifurcation’ and the amounts apportioned to the loan and the derivative components would - for A Ltd - be the same if A Ltd lent £1m to B Ltd for 3 years at 5 per cent interest, on terms that the redemption amount exactly tracked the value, up or down, of the ordinary shares in B Ltd’s parent company, X plc. Where A Ltd is not a financial concern, it would be required to account separately for the loan and the embedded ‘contract for differences’.
For B Ltd, the asset-linked security represents a hybrid instrument, not a compound financial instrument - it has a debtor loan relationship containing an embedded derivative (related to the value of X plc’s shares) rather than an equity component linked to its own share capital. So, just like A Ltd, B Ltd must account for the embedded derivative at fair value. And, just like A Ltd, it will ideally value the embedded contract for differences on the basis of the derivative’s own terms; but, where that is not possible, it will use the difference between the overall fair value of the instrument and the value of the financial liability.