Convertible notes – Are you accounting for these correctly (Part 4)?

In the current economic climate, we continue to see different types of convertible note arrangements, typically entered into by companies needing to offer attractive returns in order to obtain funds from lenders and investors.

Over the past few months we have been looking at some practical aspects regarding accounting for convertible notes, including an overview of the requirements in Accounting news, March 2018, a detailed example of a convertible note classified as a compound financial instrument in Accounting News, April 2018, and a detailed example of a convertible note with an embedded derivative liability in Accounting News, May 2018.

As noted in these previous articles, in order for a conversion feature to be classified as ‘equity’, the ‘fixed for fixed’ test in IAS 32 Financial Instruments: Presentation must be met, i.e. at initial recognition, the conversion feature gives the holder of the convertible note the right to convert into a fixed number of equity securities of the issuer. This month we look at common scenarios encountered in practice where:

  • The conversion features fail ‘equity’ classification, and
  • The conversion features would meet the requirements for ‘equity’ classification.

Scenarios where the conversion feature fails equity classification

‘Ratchet’ feature

A ‘ratchet’ feature is an anti-dilution provision that adjusts the conversion ratio if there are subsequent new issues of shares.

Example

Entity C issues a convertible note with a face value of $1,000, maturing three years from its date of issue.

The note pays a 10% annual coupon and, unless converted into shares, will be repaid in cash on maturity. 

The holder has an option, exercisable at any point during the life of the note, to convert the note into the issuer’s shares, at $1 per share.  However, if shares are issued for less than $1 during the outstanding term of the note, then the conversion price is reset to the new share issue price.  The purpose of such a clause is to protect the note holder from dilution in the value of its conversion option at $1 per share.

When accounting for this type of the note, the existence of the ‘ratchet’ feature has modified the potential number of shares to be issued to a variable number and therefore as a whole, the conversion feature has violated the ‘fixed-for-fixed’ criterion for equity classification and instead contains two embedded derivative features, being:

  1. $1 conversion option, and
  2. The ratchet feature. 

These two features are accounted for as a single instrument because the exercise of one of them automatically results in the lapse of the other.

Convertible note denominated in a foreign currency

It is common for international companies to raise funds via convertible notes issued in a currency other than their functional currency.  Although the issue and repayment amount in foreign currency may be fixed, when converted back to the entity’s functional currency it results in a variable amount of cash (that is, a variable carrying amount for the financial liability that arises from changes in exchange rates), and hence failure of the ‘fixed-for-fixed’ criteria for equity classification. 

The conversion feature is therefore a derivative liability, with the value of the conversion feature dependent on foreign exchange rates.  This means that the foreign exchange feature is an embedded derivative that must be accounted for separately under IFRS 9 Financial Instruments/IAS 39 Financial Instruments: Recognition and Measurement.

Variable conversion price limited to ‘cap’ and/or a ‘floor’

Some convertible notes contain provisions that limit the variability of the conversion price within a certain range.  These provisions can set an upper/lower limit to the conversion price (cap/floor), or it can set both an upper and a lower limit to the conversion price (often refer to as a collar). 

These notes have a potential to convert at either a variable or a fixed number of shares dependent on the share price, and this violates the fixed-for-fixed criterion for equity classification.  The options embedded in these conversion features are accounted for as embedded derivative liabilities.

Scenarios where the conversion feature still meets the equity classification

Some conversion terms initially appear to have breached the ‘fixed-for-fixed’ criterion. However, in practice equity classification may still apply. 

‘Loyalty bonus’ issues

In addition to granting the holder the option to convert the principal amount into a fixed number of shares, some conversion features:

  • Grant the holder the option to receive a fixed coupon payment in cash, or to convert the ‘accrued’ interest into additional shares at a fixed rate of exchange, or
  • Grant the holder a set number of additional shares at on each anniversary date of the note being issued.

There is a debate as to whether these terms fail the ‘fixed-for-fixed’ criterion, since the number of shares to be converted is variable dependent on the passage of time. In practice, the usual treatment for these terms is to assume that the ‘fixed-for-fixed’ criterion is met because the number of shares is predetermined at the outset, and the only variable is the passage of time. The additional shares issued at each anniversary date are considered as a series of predetermined fixed issues.

In contrast, an arrangement in which the coupon payment was at a variable rate would fail equity classification.  This is because the arrangement contains an additional variable feature (the variable interest rate) which means that the number of shares to be issued in future will vary in response to changes in benchmark interest rates.

Adjustments from a stock split or bonus issue

The terms of a convertible note may include an anti-dilution protective clause for the note holder that adjusts the conversion ratio in the event of a flotation, a stock split or for the payment of dividends to existing shareholders.  Prima facie, the inclusion of such clause would violate the ‘fixed–for–fixed’ principle because it would result in a variable number of shares being issued. However, a widely held view in practice is that such variability does not necessarily result in a violation of the ‘fixed –for-fixed’ criteria provided the following conditions are met:

  • The instrument would otherwise meet the ‘fixed-for-fixed’ requirement, and
  • The anti-dilution clause was added only to maintain the relative rights of the shareholders and note holders, and its effect is that those relative rights remain exactly the same immediately before and immediately after the event that gives rise to the anti-dilution adjustment.