Convertible bond – basic ‘split accounting’22
An entity, whose functional currency is the Euro, issues 2,000 convertible bonds. The bonds have a three-year term, and are issued at par with a face value of €1,000 per bond, giving total proceeds of €2,000,000. Interest is payable annually in arrears at a nominal annual interest rate of 6% (i.e. €120,000 per annum). Each bond is convertible at any time up to maturity into 250 ordinary shares. When the bonds are issued, the prevailing market interest rate for similar debt without conversion options is 9% per annum. The entity incurs issue costs of €100,000.
The economic components of this instrument are:
- a liability component, being a discounted fixed rate debt, perhaps with an imputed holder”s put option (due to the holder”s right to convert at any time), and
- an equity component, representing the holder”s right to convert at any time before maturity. In effect this is a written call option (from the issuer”s perspective) on American terms (i.e. it can be exercised at any time until maturity of the bond).
The practical problem with this analysis is that it is not clear what is the strike price of the holder”s options to put the debt and call for shares, specifically whether it is the €2,000,000 face value of the bonds or the discounted amount at which they are recorded until maturity. Perhaps for this reason, IAS 32 does not require the true fair values of these components to be calculated.
Instead the liability component is measured first at the net present value of the maximum potential cash payments that the issuer could be required to make. The difference between the proceeds of the bond issue and the calculated fair value of the liability is assigned to the equity component. The net present value (NPV) of the liability component is calculated as €1,848,122, using a discount rate of 9%, the market interest rate for similar bonds having no conversion rights, as shown.
|
Discount factor |
NPV of cash flow |
||
|
Year |
Cash flow |
(at 9%) |
|
|
1 |
Interest |
120,000 1/1.09 |
110,092 |
|
2 |
Interest |
120,000 1/1.092 |
101,001 |
|
3 |
Interest and principal |
2,120,000 1/1.093 |
1,637,029 |
|
Total liability component |
1,848,122 |
||
|
Total equity component |
151,878 |
||
|
(balance) |
|||
|
Total proceeds |
2,000,000 |
It is next necessary to deal with the issue costs of €100,000. In accordance with the requirements of IAS 32 for such costs (see 8.1 below), these would be allocated to the liability and equity components on a pro rata basis. This would give the following allocation of the net issue proceeds.