CFM25020 - Accounting for corporate finance: hybrid debt: accounting treatment

Hybrid debt: accounting treatment

Prior to the implementation of IAS (CFM21000 sets out when IAS became effective and how it was incorporated into UK GAAP) the standard applying to hybrid debt was FRS 4.

Under FRS 4, the issuer of convertible debt measured such debt at cost (less issue costs) as a single liability. On conversion, equity was issued and measured at the value of the liability on the date of conversion.

The holder of the debt held the asset at cost or market value.

Hybrid debt under IAS

Prior to IAS, most derivative contracts did not appear on the balance sheet of an entity, because there was little or no economic cost to be recorded at historic cost. Under IAS, however, the general rule for derivative contracts is that they do appear on the balance sheet measured at fair value, and changes in fair value are taken to the income statement.

Hybrid debt by its very nature will frequently contain within the overall debt contract (the ‘host contract’) a derivative. This is termed an ‘embedded derivative’ (see CFM25030). IAS 39 often requires the host contract and embedded derivative to be separated into two notional contracts (a process known as ‘bifurcation’), the derivative element being treated as if it was a stand-alone derivative while the equity element is treated as an equity instrument. See CFM25040 for more detail on when separation is required.