A company issues a 3-year convertible bond at its par value of
£1 million, which carries an interest coupon of 5%, payable
annually in arrears.
The company must account separately for the debt and equity
components.
The fair value of the liability as a whole is £1
million, the proceeds of the debt issue.
In order to value the bond without the conversion option, the
company needs to consider what the market rate of interest would be
were it to issue a bond on similar terms but carrying no right to
convert into shares. Suppose the market rate were 7%. The fair
value without the conversion option will be the net present value
of the cash flows receivable (interest receipts of £50,000 in
years 1, 2 and 3, plus repayment of £1 million at the end),
discounted at 7%. The fair value is £947,513.
The value of the equity component is the difference between
the two figures, £52,487.
The equity element is not subsequently remeasured. The debt
element is measured at amortised cost, using the effective interest
rate method, so any issue costs will be spread over the life of the
instrument.
Suppose that, at maturity, the holder exercises the
conversion option and the company issues 1 million £1 ordinary
shares to the investor. The company derecognises the £947,513
liability component and recognises it in equity. The £52,487
remains in equity, although it may be moved from one line within
equity to another. There is no impact on the profit and loss
account.
