Compiled by: Murtaza Quaid

How to account for Compound Financial Instrument?

[IFRS Box – IFRS Kit]
Compound financial instruments became very common way of raising cash by many companies, but
their shareholders don’t like them that much. Why?

Because many compound financial instruments contain the option to convert into shares. Just imagine
you purchased convertible bond that gives you the right to take issuer’s share instead of redemption in
cash. If the issuer is some solid and quickly growing company, then this option is nice for you because
you can gain lots of money in the future from increasing share’s price.

But you can imagine that current issuer’s shareholders don’t like your option—because this option can
reduce their share in the company. It’s logical—because if new shares are issued and current
shareholders don’t get them, then their proportional share goes down.

In order to clearly show the potential risk of reducing shareholder’s share in the company, standard IAS
32 Financial Instruments: Presentation clearly sets the rules for accounting and presentation of the
compound financial instruments.

What is a compound financial instrument?

Standard IAS 32 defines compound financial instrument as a non-derivative financial instrument that,
from the issuer’s perspective, contains both liability and an equity component.

It means that the issuer of such an instrument cannot simply show it purely as a liability or purely as an
equity, because this instrument contains a little bit of both. Wanna examples? Here they are:

Example 1: A bond convertible into a fixed number of issuer’s shares

When the bond is convertible into shares, it means that the bond holder can get paid either by cash at
maturity or exchange this bond for some fixed number of issuer’s shares. It is a compound financial
instrument because it contains 2 elements:

 a liability = issuer’s obligation to pay interest or coupon and POTENTIALLY, to redeem the bond in
cash at maturity (or a conventional loan); and
 an equity = the holder’s call option for issuer’s shares (or in other words, holder can chose to get
fixed amount of shares instead of fixed amount of cash).

Example 2: A preference share redeemable at issuer’s discretion with mandatorily paid

dividends
If an issuer issuers such a share, he must pay dividends each year (or in line with terms of the share), but
the issuer can also chose whether and when he redeems the share. Again, this is a compound financial
instrument with 2 elements:

 a liability = issuer’s obligation to pay dividends; and

 an equity = the issuer’s call option for own shares (or in other words, issuer can chose to pay fixed
amount of cash for fixed amount of shares).

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 Compiled by: Murtaza Quaid

How to account for compound financial instruments

Before outlining the accounting treatment let me stress that the accounting treatment in issuer’s
financial statements significantly differs from accounting treatment in holder’s financial statements.

Issuer is someone who creates the compound financial instrument—we can equally call him “borrower”
because he raises money by issuing compound financial instrument.

As opposite, holder is someone who acquires compound financial instrument and we can call him
“lender”.

Accounting treatment in issuer’s financial statements

IAS 32 requires so-called “split accounting” for compound financial instruments. It means that the issuer
must perform the following steps on initial recognition:

 Step 1: Identify the various components of the compound financial instrument.

That’s obvious. The issuer must clearly identify what the liability element is and what the equity
element is—just refer to examples above.

 Step 2: Determine the fair value of the compound financial instrument as a whole.

Basically this shouldn’t be any problem, because if the transaction happens under market
conditions, then the fair value of the instrument as a whole equals to cash received in return for the
instrument.

 Step 3: Determine the fair value of the liability component.

The fair value of the liability component can be determined at fair value of a similar liability that
does NOT have any associated equity conversion feature. So for example, the fair value of the
liability component of the convertible bond equals to fair value of the bond with the same
parameters (maturity, coupon rate, etc.) but without the option to convert into issuer’s shares.

 Step 4: Determine the fair value of the equity component.

The equity component is determined simply as the fair value of the compound financial instrument
as a whole (step 2) less the fair value of the liability component (step 3).

Now, if issuer incurs certain costs associated with the issue of compound financial instruments, these
should be allocated to the liability and equity components proportionally.

Subsequently, after initial recognition, the equity component remains untouched—so it is NOT
remeasured and stays where it is until the final settlement.

On the other hand, liability component is accounted for in line with IFRS 9—either by application of
effective interest rate method or at fair value through profit or loss—that depends on the classification
of the liability.

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 Compiled by: Murtaza Quaid

Accounting treatment in holder’s financial statements

This is really a different cup of tea. When holder buys a compound financial instrument, for example—
convertible bond, it also has 2 components:

 A derivative financial asset—which is the call option for issuer’s share in this example, and
 A receivable towards issuer—which is the loan provided to issuer by acquiring his bond.

So the holder has 2 assets in fact. In this case, a derivative financial asset shall be measured at first (at
fair value of the option) and the fair value of the receivable shall be calculated as a residual. However,
that’s not the main topic of this article—I just wanted you to know and to realize this 🙂🙂

Compound financial instruments vs. Hybrid financial instruments

To finish this article, let me explain what the difference between “compound” and “hybrid” financial
instruments is because I noted that many people interchange these 2 terms—yet they mean totally
different things:

 Compound financial instrument: that’s the NON-DERIVATIVE financial instrument containing

both equity and liability components.
 Hybrid financial instrument or hybrid contract is the one containing embedded derivative.
While accounting for compound financial instrument is arranged by IAS 32 Financial Instruments:
Presentation, rules for identification and accounting for embedded derivatives are arranged by IFRS 9
Financial Instruments.

So just be careful to look for the right thing 🙂🙂

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