Compound Financial Instrument as per IFRS 9 is a ‘Financial Instrument’ that contains BOTH a liability component and an equity component.
It is a Non-Derivative Financial Instrument that CONTAINS two components:
- Financial Liability – Issuer’s contractual obligation to pay cash (i.e. principal and interest)
- Equity Instrument – A embedded option to convert the loan into equity shares of the issuer
An EXAMPLE is a ‘Convertible Bond‘. (The company issues a bond that can be converted into equity in the future or redeemed for cash).
Initially, it is a liability but it has a call option on the company’s equity embedded within it.
A Convertible Bond pays a ‘Rate of Interest’ that is LOWER than the Market Rate for a Non-Convertible Bond (Straight Bond) with the same risk profile.
This is because the ‘Conversion Terms’ allow the bondholder to convert the bond into shares at a rate that is LOWER than the market rate.
Table of Contents
Compound Financial Instrument – Recognition (As Per IFRS 9)
On Initial Recognition, it is required to be split into Liability and Equity Component as follows:
| Fair value of the instrument as a whole (i.e. Proceeds from the issue of bond) | XXX |
| Less: Fair value of the liability component (Present value of contractually determined future cash flows discounted at the ‘Market Interest Rate’ applicable to the comparable instrument but WITHOUT conversion option) | (XXX) |
| → Equity component (‘Residual Amount’) | XXX |
The SPLIT is made on initial recognition of the instrument and is NOT subsequently revised due to a change in interest rate, share price, or possibility of the exercise of the conversion option.
‘Transaction/Issue Cost’ will be allocated to each component on a pro-rata basis of initially recognized amounts of equity and liability.
1. If Conversion is Exercised
De-Recognize the liability and RECOGNIZE it as equity as follow:
| Debit: Financial Liability Credit: Share Capital + Premium |
The original ‘Equity Component’ remains as equity (may be transferred within equity).
Early Conversion: If a favorable conversion ratio is offered for early conversion, the fair value of additional shares given under the revised terms is recognized as a loss in P&L.
2. If Conversion is Not Exercised
De-Recognize the liability as follow:
| Debit: Financial Liability Credit: Cash/Bank |
Early Repurchase: Allocate the consideration paid and transaction costs for ‘early repurchase‘ to the liability and equity components in the same manner that is used in the original allocation of the proceeds received by the entity when the convertible instrument was issued.
Any gain or loss is RECOGNIZED as follows:
- Gain or loss relating to the liability component is recognized in P&L; AND
- Consideration of equity component is recognized in equity.
Synopsis
Compound Financial Instrument(s) typically involve a combination of debt and equity. IFRS 9 introduced a ‘Dual Measurement’, classifying these instruments either as at fair value through profit or loss (FVPL) or at amortized cost, depending on their contractual cash flow characteristics and the entity’s business model.
Chartered Accountant – ICAP
Bachelor of Accounting (Honours) – AeU, Malaysia