A compound financial instrument is a type of financial instruments that has the characteristics of both equity and financial liability. Common examples of compound financial instruments include convertible loans and convertible preference shares.
A convertible loan is a type of borrowing that gives the lender an option at the time of settlement of loan. The lender can choose to get his loan settled by the borrowing company either:
- By payment of cash (like in a normal loan); or
- By issuance of predetermined number of the Company’s shares.
Usually, this option comes with a price. A convertible loan has a relatively lower interest rate compared to similar non-convertible loans in market. However, investors are willing to let go the interest income for the sake of receiving shares of the company at the settlement date.
Let’s see how accounting of compound financial instruments is done.
Accounting of compound financial instruments
First step is to allocate the fair value of the compound instrument into its components, i.e. allocating the fair value into:
- Equity component; and
- Financial liability component
Equity component represents a reserve for potential shares as the investor can choose to get his investment realized in the form of shares. Whereas the financial liability component represents the company’s obligation to pay interest and the potential obligation to pay cash at settlement. Financial liability component is determined by calculating the present value of future cashflows (interest and principal loan). It is then compared with the fair value of the compound financial instrument and the residual value is considered as equity component.
For instance, a convertible loan’s liability component will be determined by calculating the present value of future cash flows. Market interest rate of similar non-convertible loan is used to discount the future cash flows. Present value calculated represents the fair value of financial liability component. It is then compared to the fair value of compound financial instrument and the residual value is recognized as equity component.
Subsequently, no change is made to the equity component till the settlement date. At the settlement date, if the investor opts for issuance of shares, the reserve is used for issuance of shares. If the investor opts for payment of cash, the reserve is transferred to retained earnings.
As for the financial liability component, it is accounted for using the effective interest rate method. Market interest rate used for discounting the future cash flows will be the financial liability’s effective interest rate. Financial liability component will be carried in the books as per the following formula:
Financial liability component = Opening balance + interest expense – interest paid
At the settlement date, financial liability will be settled either by paying cash or issuing shares.
Let’s see an example of a convertible loan to understand the accounting of compound financial instruments.
On 1 January 20X1, ABC Company issues a convertible loan instrument of $300,000 with a nominal interest rate of 4% per annum. Interest is payable annually in arrears. Market interest rate for a similar non-convertible loan is 10% per annum. After 4 years, lender can opt to get the full amount repaid in cash or can choose to get 280,000 shares of $1 each.
How will the convertible loan be accounted for by ABC Company?
Fair value of the compound instrument is the amount of cash received by the company i.e. $300,000. This amount is to be allocated into the equity component and the financial liability component.
Using the market interest rate of 10% for similar non-convertible loan, we’ll calculate the present value of future cash flows (interest and principal repayment).
PV of future cash flows = 12,000/(1.10)1 + 12,000/(1.10)2 + 12,000/(1.10)3 + 12,000/(1.10)4 + 300,000/(1.10)4
PV of future cash flows = $242,942
We have calculated the liability component. Difference between fair value of the convertible loan and the financial liability component calculated above represents the equity component of the convertible loan.
Equity component = $300,000 – $242,942 = $57,058
Subsequently, the equity component will be unchanged, whereas the financial liability component will be accounted for using the following amortized cost table.