This guidance applies to periods of account beginning on or after 1 January 2005
A Ltd subscribes for a 3 year bond issued by X Ltd at its par
£1m, carrying interest at 5 per cent. The bond redeems for
cash £1million or, at A Ltd’s option, may be converted
into 10,000 ordinary £5 shares in X Ltd.
A Ltd is required to account separately for the loan and the
option. At acquisition, it considers the fair value of the security
as a whole to be its issue price, £1m. To value the security
without the conversion option, A Ltd considers what market rate of
interest it would have required, had it been issued on similar
terms but without the conversion rights. Suppose that was 7 per
cent. The fair value without the embedded option is then equal to
the net present value of the cashflows receivable (interest
receipts of £50,000 in years 1, 2, and 3 plus repayment of
£1million at the end) discounted at 7 per cent. This gives an
initial fair value for the “host” loan of
£947,513. The initial fair value of the option is then the
difference between this amount and £1m, £52,487.
A Ltd accounts as if it had paid X Ltd £947,513 for the
loan relationship and £52,487 for granting the conversion
option. In effect, the loan is treated as purchased at a discount
of £52,487.
Subsequently, A Ltd may account for the loan relationship on
an amortised cost basis, for example if it classifies the
convertible as a held to maturity investment (see
CFM16125), accruing the “implied
discount” of £52,487 over the term of the loan (
CFM16640). But it must measure the
derivative component at fair value at each balance sheet date.
If shares in X Ltd are regularly traded, sufficient
information may be available to use a standard valuation model
(such as Black-Scholes) to value A Ltd’s option to acquire
the shares, both on initial recognition and subsequently. If that
is not possible, however, it must revalue the derivative component
of the convertible on subsequent dates by again taking the
difference between the fair value of the instrument as a whole, and
the fair value of the loan component.
But if A Ltd cannot value the derivative reliably even by
this method, then it must account for the convertible as a whole as
held for trading, measuring it at fair value and crediting or
debiting fair value changes to profit and loss account.
The issuer, X Ltd, may also be required to account separately
for the equity component – its obligation to issue its own
shares if the conversion option is exercised. If so it will
determine the value of the equity component as the difference in
fair value between the instrument as a whole, and its financial
liability.
This equity component is not subsequently revalued. So even
if X Ltd initially values the equity component at £52,487
– the same value that A Ltd places on its embedded option
– there will not be any subsequent parity between the balance
sheets of issuer and holder, because different accounting rules
apply.
Even initially, X Ltd may not arrive at exactly the same
split as the holder, as it may take a different view on what rate
of interest it would have paid, had it not granted the option.
Additionally the issuer will apportion any direct issue costs in
the same ratio. For convenience, assume that X Ltd arrived at the
same split – £947,513 and £52,487 – and that
its issue costs were £20,000. It apportions these rateably
between the components: £18,950 and £1,050. The initial
fair values of the loan and option obligations are then
£928,563 and £51,437. These total £980,000, being X
Ltd’s net proceeds of issue after issue costs.
The mechanics of “bifurcation” and the amounts
apportioned to the loan and the derivative components would –
for A Ltd - be the same if A Ltd lent £1m to B Ltd for 3 years
at 5 per cent interest, on terms that the redemption amount exactly
tracked the value, up or down, of the ordinary shares in B
Ltd’s parent company, X plc. Where A Ltd is not a financial
concern, it would be required to account separately for the loan
and the embedded “contract for differences”.
For B Ltd, the asset-linked security represents a hybrid
instrument, not a compound financial instrument – it has a
debtor loan relationship containing an embedded derivative (related
to the value of X plc’s shares) rather than an equity
component linked to its own share capital. So, just like A Ltd, B
Ltd must account for the embedded derivative at fair value. And,
just like A Ltd, it will ideally value the embedded contract for
differences on the basis of the derivative’s own terms; but,
where that is not possible, it will use the difference between the
overall fair value of the instrument and the value of the financial
liability.
