In practice, many conversion features in convertible notes fail equity classification, which means that the conversion feature is a financial liability.
The reason that many conversion features fail equity classification is that they contain contractual terms that result in the holder of the conversion feature having rights that are different to those of existing shareholders. This is because the contractual terms mean that either:
- The number of shares to be issued varies
- The amount of cash (or carrying amount of the liability) converted into shares varies
- Both the number of shares and the amount of cash (the carrying amount of the liability) vary.
The commercial effect of this is that the holder of the conversion feature obtains a different return in comparison with an investor that holds equity shares.
Conversion features that fail equity classification are derivatives because they are either written options (that is, options that provide the holder with a choice over whether the convertible note is exchanged for shares or cash) or forward contracts under which an entity will issue shares in order to extinguish an obligation, with no cash settlement alternative.
This links to the definition of a derivative in IFRS 9, with all three of the characteristics of a derivative being met. These characteristics are:
- The value of the conversion feature changes in response to the share price of the issuer
- The investment required to purchase the option (which is the present value of the reduction in interest rate that is paid on the convertible note in comparison with an loan note with no conversion feature) is less than would be required to purchase the equivalent number of shares (the comparison that is made is to compare the cost of acquiring the conversion feature with the cost of acquiring other instruments that would have a similar response to future changes in the fair value of the issuer’s shares – which would be an investment in the shares themselves)
- The conversion feature is settled at a future date.
Conversion features that fail equity classification and are accounted for as derivative liabilities are typically accounted for separately from the host instruments. This is because the fair value of the conversion feature is affected by changes in the fair value of the issuer’s shares, and the fair value of the host loan is not. This means that the conversion feature (an embedded derivative) is not what IFRS 9 refers to as being ‘closely related’ to the host contract.
The effect of this is that for many convertible notes, a host loan will be accounted for at amortised cost, with an embedded derivative liability being measured at fair value with changes in value being recorded in profit or loss.
The terms of some convertible notes which contain conversion features that are required to be accounted for as derivative liabilities can mean that the accounting for each of the separate components can become complex. One approach which can simplify the accounting is to use the IFRS 9 ‘fair value option’. Under this approach, a contract that contains one or more embedded derivatives that would normally be required to be accounted for separately can instead be accounted for in its entirety at fair value through profit or loss. Although this may appear to be an attractive option, it can give rise to additional volatility in amounts reported in profit or loss. This is because not only the embedded derivative(s), but also the host loan, will be measured at fair value with this being affected by factors which include changes in interest rates, and changes in the issuer’s own credit rating (because this affects the rate of interest that the issuer would have to pay for new borrowings).
The remainder (and the numbers) illustrates the accounting approach to be followed where the IFRS 9 ‘fair value option’ is not used. This means that the host contract will be accounted for at amortised cost.
The accounting for a convertible note with an embedded derivative liability is set out in IFRS 9. The embedded derivative liability is calculated first and the residual value is assigned to the debt host liability component (IFRS 9 B3.2.4). This is in contrast to where a convertible note is a compound instrument with an equity component, where the fair value of the liability component is calculated first with the equity being residual.
Determining the fair value components of a convertible note with a liability and an embedded derivative component: