Intermediate Accounting — Compound Financial Instruments: Splitting Convertible Bonds and Bonds with Warrants

A convertible bond (CB) is a bond with a right to convert it into shares. Investors accept lower interest in exchange for the conversion right. K-IFRS 1032 (IAS 32) requires the issuer to present such compound financial instruments split into a liability component and an equity component. Ordinary bonds were covered in chapter 7 and the principles for distinguishing liabilities from equity in chapter 9.

1. The principle of splitting: liability first, equity as the residual

Because equity is a residual interest, the fair value of the liability component is measured first, and the remainder of the issue proceeds is assigned to the equity component. The liability component is the future cash flows (interest, principal and any redemption premium) discounted at the market rate for a similar bond without a conversion option.

2. Without a redemption premium

At the beginning of 20X1 company CC issued at par a three-year convertible bond with a face amount of ₩10 million and a coupon of 2% (paid at year-end). The conversion price is ₩10,000 per share (par ₩5,000). The market rate for a straight bond on the same terms is 7%.

• Liability component: $20 \times 2.6243 + 1{,}000 \times 0.8163 ≈ 868.8$ (₩10,000)
• Conversion option: $1{,}000 - 868.8 = 131.2$

The coupon is 2%, but interest expense in the income statement is around 7%. The interest forgone in exchange for the conversion option is in substance a cost.

A. Conversion

If the whole bond is converted at the beginning of 20X2, the liability component of ₩9.096 million and the conversion option of ₩1.312 million — ₩10.408 million in total — move to equity. 1,000 shares are issued, share capital is $1{,}000 \times 5{,}000$ = ₩5 million, and the remaining ₩5.408 million is share premium. Conversion gives rise to no gain or loss.

3. With a redemption premium

To guarantee investors a certain yield if they hold to maturity without converting, a redemption premium is paid. Adding a guaranteed yield of 4% to the terms in section 2, the premium is the difference between the guaranteed yield and the coupon, compounded.

• Liability component: $20 \times 2.6243 + 1{,}062.4 \times 0.8163 ≈ 52.5 + 867.2 = 919.7$ (₩10,000)
• Conversion option: $1{,}000 - 919.7 = 80.3$

A redemption premium enlarges the liability component and shrinks the conversion option. On conversion, the liability for the redemption premium accrued to that date also moves to equity.

4. Bonds with warrants (BW)

A BW keeps the bond outstanding and carries a right to buy new shares by paying additional cash. The splitting method is the same as for a convertible bond. The difference is on exercise: a convertible bond turns into shares, whereas with a BW — even a non-detachable one — the bond remains and cash equal to the exercise price comes in. The warrant component for the exercised portion is transferred to share premium.

5. Early redemption and repurchase by the issuer

When a convertible bond is bought back before maturity, the consideration paid is split between the fair value of the liability component at that date and the equity component. The difference between the liability component’s fair value and its carrying amount goes to profit or loss; the difference between the amount allocated to equity and the carrying amount of the conversion option goes to equity. The residual goes to equity, just as on issue.

Check your understanding

At the beginning of 20X1 company DD issued a two-year convertible bond with a face amount of ₩20 million and a coupon of 3% (paid at year-end) for ₩19.8 million. There is no redemption premium and the market rate on straight debt is 8% (two-year factors: single sum 0.8573, annuity 1.7833). What are the conversion option and interest expense for 20X1?

The liability component is $60 \times 1.7833 + 2{,}000 \times 0.8573 = 107.0 + 1{,}714.6 = 1{,}821.6$ (₩10,000). The conversion option is the proceeds of ₩19.8 million less this, ₩1.584 million. Interest expense for 20X1 is $1{,}821.6 \times 8\% ≈ 145.7$, and the liability component grows by the ₩857,000 difference from cash interest of ₩600,000.

References

• Korea Accounting Standards Board, K-IFRS 1032 Financial Instruments: Presentation (compound financial instruments)
• Korea Accounting Standards Board, K-IFRS 1109 Financial Instruments (embedded derivatives)
• Donald Kieso, Jerry Weygandt and Terry Warfield, Intermediate Accounting: IFRS Edition, ch. 16