AE 18 — Intermediate Accounting II, Topic 3

Compound Financial Instruments

Procedures in accounting compound financial instruments and its effect to equity
accounts

Miles N.M. Santos, CPA

Assistant Professor I
Faculty — College of Business, Management and Accountancy
Colegio de la Purisima Concepcion

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Compound financial instruments

Compound financial instruments are financial instruments that contains both the
liability and an equity element from the perspective of the issuer. [IAS 23, par. 28]
To illustrate, a compound financial instrument contains two components. One is a financial liability, namely the
issuer's contractual obligation to pay cash, and the other is an equity instrument, namely the holder's option to
convert into or acquire common shares.

The two most common examples of these instruments are:

1. Bonds payable issued with share warrants

2. Convertible bonds payable

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Accounting procedures for bonds issued with share warrants

1. Determine the market value of the bonds without warrants. In the absence thereof,
compute for the present value of the bonds.

2. Deduct the amount determined or computed from Step 1 from the total cash
consideration received by the issuer. The difference is accounted as share warrants
outstanding. This is known as split accounting or bifurcation.

Share warrants outstanding is an equity account, particularly, a classification of share

premium.

3. In the exercise of the warrants, multiply the number of shares acquired by the holder
by its exercise price. The aggregate amount of the total exercise price plus the portion of
share warrants exercised shall be deducted by the par value of the shares acquired. The
difference shall be accounted as an increase in share premium account.

4. In case there are unexercised share warrants, the unexercised share warrants shall be
closed to share premium.

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 An entity issued 5,000 10-year bonds payable, face amount P1,000 per bond, at 105.

Each bond is accompanied with one warrant that permits the bondholder to purchase 20 equity shares, par
P50, at 55 per share. The market value of the bond ex-warrants at the time of issuance is 98.

During the same year, 60% of the share warrants are exercised. The remaining share warrants are expired
at the end of the year.

Step 1: Determine market value of the bonds without warrants.

In this example, the market value of the bonds is P4,900,000. (5,000,000 x 0.98)

Illustration Bonds issued with share warrants 4

 Step 2: Perform bifurcation or split accounting.

Here, the share warrants outstanding which is the equity component of the bonds is P350,000.

Cash consideration received by the issuer

5,250,000
(P5,000,000 x 1.05)

Less: Market value of the bonds without warrants (4,900,000)

Equity component 350,000

Cash 5,250,000

Discount in bonds payable 100,000

Bonds payable 5,000,000

Share warrants outstanding 350,000

Illustration Bonds issued with share warrants 5

 Step 3: Account for the exercise of share warrants.

Here, the total share warrants exercised is P210,000 and the total number of shares exercised is 60,000

Shares exercised [(100,000 x 60%) x P55] 3,300,000

Add: Share warrants exercised (350,000 x 60%) 210,000

Less: Par value of shares exercised [(100,000 x

(3,000,000)
60%) x P50]

Increase in share premium 510,000

Cash 3,300,000

Share warrants outstanding 210,000

Share capital 3,000,000

Share premium 510,000

Illustration Bonds issued with share warrants 6

 Step 4: Close to share premium unexercised share warrants.

The remaining share warrants is P140,000 (P350,000 - 210,000) or 40% of P350,000

Share warrants outstanding 140,000

Share premium 140,000

Illustration Bonds issued with share warrants 7

Accounting procedures for convertible bonds

1. Determine the issue price of bonds without the conversion privilege. In the absence thereof,
compute for the present value of the bonds.

2. Deduct the amount determined or computed from Step 1 from the total cash consideration received
by the issuer. The difference is accounted as share premium - conversion privilege. This is known as
split accounting or bifurcation.

Share premium with conversion privilege is an equity account, particularly, a classification of share
premium.

3. In the conversion of bonds, determine the aggregate amount carrying amount of bonds plus the share
premium conversion privilege. This amount shall be deducted by the par value of shares converted . The
difference shall be accounted as an increase in share premium account.

Any costs incurred for the conversion of bonds shall be treated as a direct deduction from share
premium.

4. In case there are no conversion of share premium - conversion privilege, the remaining share
premium with conversion privilege shall be closed to share premium.
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 An entity issued 5,000 10-year bonds payable, face amount P1,000 per bond, at 105.

Each bond is convertible to 20 equity shares, par P50. The issue price of the bonds without the
conversion feature at the time of issuance is 98.

At year-end, these bonds were converted to share capital. The carrying amount of the bonds at year-end is
P4,850,000. There are no accrued interests.

Step 1: Determine issue price of bonds without the conversion privilege.

In this example, the issue price without conversation feature is 4,900,000. (5,000,000 x 0.98)

Illustration Convertible bonds 9

 Step 2: Perform bifurcation or split accounting.

Here, the share premium with conversion feature which is the equity component of the bonds is P350,000.

Cash consideration received by the issuer

5,250,000
(P5,000,000 x 1.05)

Less: Market value of the bonds without warrants (4,900,000)

Equity component 350,000

Cash 5,250,000

Discount in bonds payable 100,000

Bonds payable 5,000,000

Share premium - conversion privilege 350,000

Illustration Convertible bonds 10

 Step 3: Account for the conversion of bonds.

Here, the total share warrants exercised is P210,000 and the total number of shares exercised is 60,000

Carrying amount of the bonds 4,850,000

Add: Share premium - conversion privilege 350,000

Less: Par value of shares exercised [(5,000 x 20) x

(5,000,000)
P50]

Increase in share premium 200,000

Bonds payable 5,000,000

Share premium - conversion privilege 350,000

Discount on bonds payable 150,000

Share capital 5,000,000

Share premium 200,000

Illustration Convertible bonds 11