prepare any necessary entries in e s financial statements as at dec 31 for the years 613302

Compound financial instrument

An entity issues a zero-coupon convertible loan of €1,000,000 on 1 January 2014 repayable at par on 1 January 2017. In accordance with IAS 32, the entity classifies the instrument”s liability component as a liability and the equity component as equity. The entity assigns an initial carrying amount of €750,000 to the liability component of the convertible loan and €250,000 to the equity component. Subsequently, the entity recognises the imputed discount of €250,000 as interest expense at the effective annual rate of 10% on the carrying amount of the liability component at the beginning of the year. The tax authorities do not allow the entity to claim any deduction for the imputed discount on the liability component of the convertible loan. The tax rate is 40%.

Temporary differences arise on the liability element as follows (all figures in € thousands).

Balance carried forward at end of previous period plus 10% accretion of notional interest less repayments.

The deferred tax arising at 1 January 2014 is deducted from equity. Subsequent reductions in the deferred tax balance are recognised in the income statement, resulting in an effective tax rate of 40%. For example, in 2014, the entity will accrete notional interest of €75,000 (closing loan liability €825,000 less opening balance €750,000) with deferred tax income of €30,000 (closing deferred tax liability €70,000 less opening liability €100,000).

Whilst this treatment is explicitly required by IAS 12, its conceptual basis is far from clear, and causes some confusion in practice. In the first instance, it appears to contravene the prohibition on recognition of deferred tax on temporary differences arising on the initial recognition of assets and liabilities (other than in a business combination) that do not give rise to accounting or taxable profit or loss. IAS 12 argues that this temporary difference does not arise on initial recognition of a liability but as a result of the initial recognition of the equity component as a result of split accounting. [IAS 12.23].

Even if this analysis is accepted, it remains unclear why the deferred tax should be deducted from equity. It may have been seen as an application of the general allocation principle of IAS 12 that the tax effects of transactions accounted for in equity should also be accounted for in equity – see below. However, this would have been correct only if the accounting entry giving rise to the liability had been:

The actual entry was:

Therefore, in fact the general allocation rule in IAS 12 would have required the deferred tax liability to be recognised as a charge to profit or loss. This would have resulted in a ‘day one’ tax expense, suggesting that that initial recognition exception ought, in principle, to have been applied here also.

The accounting treatment required by above could be seen as no more than ‘tax equalisation’ accounting – i.e. the recognition of deferred tax of an amount that, when released to profit or loss, will yield an effective tax rate equivalent to the statutory rate. Some would question whether it is appropriate to represent as tax-deductible a charge to the income statement that in reality is not tax-deductible. Nevertheless, as noted above, this treatment is explicitly required by IAS 12.