Convertible notes – Are you accounting for these correctly? (Part 7)

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)
  • A detailed example of a convertible note with an embedded derivative liability in Accounting News (May 2018)
  • Common scenarios encountered in practice where conversion features either meet or fail equity classification (July 2018)
  • A detailed example of a convertible note converting into a variable number of shares based on the issuer’s share price at conversion date (August 2018)
  • A detailed example of a convertible note issued in a currency other than the issuer’s functional currency (September 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 a detailed example of a callable convertible note, i.e. a convertible note with a feature that allows the issuer to repay (‘call’) the note early.

Summary

Some convertible notes contain a call option which allows the issuer to repay the principal plus any outstanding accrued interest at any time during the life of the note.  From the issuer’s perspective, this call feature is a derivative because future changes in interest rates could mean that the redemption amount of the loan is less than its fair value.

However, this derivative is not accounted for as a separate embedded derivative because the repayment price is equal to the amortised cost of the host debt instrument and therefore, under one of the exceptions in IAS 39, it is considered to be ‘closely related’ to the debt host contract. Therefore no separate accounting is required for the call option.

Example: Callable convertible note (at option of issuer)

ABC Limited issues a convertible note with a face value of $10,000, maturing three years from its date of issue.

The note pays a 10% annual coupon and, on maturity, the holder has an option either to receive cash of $10,000 or 10,000 ABC Limited shares.

The value of a similar bond without the equity conversion option feature is $9,500.

The note also has a call feature which allows ABC Limited to repay the principal plus any outstanding accrued interest at any time during the life of the note. The additional call feature is determined to be worth $100 to ABC Limited.

Step one

Starting with the box on the top left hand side of the flowchart above, we consider whether there is a contractual obligation to pay cash that the issuer cannot avoid. The answer is ‘yes’ because ABC Limited must pay the annual 10% cash coupon, and it could also be required to repay the $10,000 capital amount at the end of three years if the holder chooses not to exercise the conversion option.

Step two

Step two is to consider whether IAS 32.16A-D apply. When an issuer has an obligation to repurchase financial instruments, in certain circumstances, IAS 32 Financial Instruments: Presentation, paragraphs 16A to 16D include exceptions to the usual principles for classifying financial instruments as financial liabilities. In some cases, such instruments could be classified as ‘equity’, despite having an unavoidable obligation to pay out cash. However, this exception does not typically apply to convertible instruments and is not applicable in this example.

Step three

Continuing down the right hand side of the above flow chart, we then consider whether the instrument has any characteristics that are similar to equity. The answer is ‘yes’ because the instrument contains an option to be converted into equity instruments, but the question of whether the conversion feature meets the criteria to be classified as equity is dealt with separately in Step four below.

The host debt component will be classified as a financial liability because ABC Limited has an unavoidable obligation to pay cash, and on a standalone basis there is no feature in the host debt contract that is similar to equity. 

Step four

The conversion feature is then assessed on a standalone basis using the above flowchart.  Starting with the box at the top left hand side of the diagram:

  • There is no contractual obligation to pay cash that the issuer (ABC Limited) cannot avoid.  The equity conversion feature can only be settled through the issue of equity shares, otherwise it will simply expire unexercised
  • There is no obligation to issue a variable number of shares. If exercised, the option will result in the issue of 10,000 ABC Limited shares, and
  • The book value of the convertible note is not variable, i.e. the convertible note is not denominated in a foreign currency.

The conversion feature is therefore classified as an equity component.

In addition, the note also has a call feature which allows ABC Limited to repay the principal plus any outstanding accrued interest at anytime during the life of the note. However, as discussed above, this derivative is not accounted for as a separate embedded derivative (because it is considered to be ‘closely related’ to the debt host contract).

This means that the note as a whole contains the following liability and equity components:

  • Contractual cash flows of 10% annual coupons and a cash repayment of $10,000 (liability)
  • The conversion feature to convert the liability into equity of ABC Limited (equity), and
  • The call feature (an embedded derivative that is not separated, and therefore not recognised separately from the host liability).

The fair value of the liability component is $9,400 which is the sum of the fair value of the debt host contract ($9,500) and the non-separable embedded derivative asset ($100).  The equity component would therefore be the residual, i.e. $600 ($10,000 less $9,400).

ABC Limited recognises the following journal entry at initial recognition to record the callable convertible note transaction:

Dr Cr
Cash $10,000  
Debt liability   $9,400
Equity component   $600