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. See also Convertible note with embedded derivative – Basics
Example Convertible note with embedded derivative – The numbers
Entity B issues a note with a face value of CU 1,000 which has a maturity of three years from its date of issue. The note pays a 10% annual coupon and, on maturity at the end of three years, the holder has an option either to receive a cash repayment of CU 1,000 or to convert the note into the Entity B’s shares. The note would be converted into Entity B’s shares using the average of the lowest five days value weighted average price (VWAP) in the previous 30 days prior to maturity. The conversion feature is determined to have a fair value of CU 20 at issue date.
Entity B incurred transaction costs of CU 100 in issuing the convertible note.
Analysis Convertible note with embedded derivative – The numbers
Using the flowchart above for the entire instrument, it is assessed as being a financial liability with an embedded derivative liability. The analysis is as follows:
- Step 1 is to consider whether there is a contractual obligation to pay cash that the issuer cannot avoid. The answer is yes, as the issuer has to pay an annual cash coupon and could be required to repay the capital amount at the end of three years if the holder chooses not to exercise the conversion option
- Step 2 is to consider whether IAS 32.16A-D apply. These paragraphs set out a specific and specialist exception from the requirement to classify certain financial instruments, which the issuer has an obligation (or potential obligation) to repurchase, as financial liabilities. This exception does not typically apply to convertible instruments and is not applicable in this example
- Step 3 is to consider whether the instrument has any characteristics that are similar to equity. The answer is yes as the instrument contains an option to be converted into equity instruments. The question of whether the conversion feature meets the criteria to be classified as equity is dealt with separately.
For the purposes of the compound instrument, the host debt component will be classified as a financial liability in its entirety. This is because there is an obligation to pay cash that the issuer cannot avoid (see above) and, for this component on a stand-alone basis there is no feature that is similar to equity.
The conversion feature is then assessed, again on a stand-alone basis. Starting with the box at the top left hand side of the diagram:
- There is no contractual obligation to pay cash that the issuer cannot avoid. The equity conversion feature can only be settled through the issue of equity shares, otherwise it will simply expire unexercised
- However, there is an obligation to issue a variable number of shares – the number of shares to be issued is based on the lowest 5 day VWAP in the last 30 days prior to maturity.
Consequently, the conversion feature is also classified as liability.
This means that the note contains the following components:
- Contractual cash flows of 10% annual coupons and a cash repayment of CU 1,000 (liability)
- The conversion feature to convert the liability to in to equity of the issuer at the lowest five day share price in the previous 30 days prior to maturity (an embedded derivative liability).
For convertible notes with embedded derivative liabilities, the embedded derivative liability is determined first and the residual value is assigned to the debt host liability. Therefore, the debt host liability is initially recognised at CU 980 being the residual value from deducting the fair value of the derivative liability from the transaction price (i.e. CU 1,000 less CU 20).
Transaction costs Convertible note with embedded derivative – The numbers
Transaction costs are to be apportioned to the debt liability and the embedded derivative. The portion attributed the conversion feature is immediately expensed, because the embedded derivative liability is accounted for at fair value through profit or loss. For the portion of transaction costs that are attributed to the loan, these are added to the carrying amount of the financial liability and amortised as part of the effective interest rate.
Entity B adjusts the carrying amount of the liability component for transaction costs incurred as follows:
Allocation of transaction costs Convertible note with embedded derivative – The numbers
A Fair value before transaction costs
B Transaction costs allocation
A – B = Carrying amount
CU 98 2
CU 2 4 > to profit or loss
The effective interest rate is recalculated after adjusting for the transaction costs, and for the host liability component it is 15.18 % (this is determined by establishing the rate that is required to discount the contractual cash flows back to the carrying amount, as adjusted for transaction costs). Entity B will therefore record interest expense at the effective interest rate (15.18%). The difference between interest expense (15.18%) and the cash coupon (10%) increases the carrying amount of the liability so that, on maturity, the carrying amount is equal to the cash payment that might be required to be made.
Convertible note with embedded derivative – The numbers
The following table shows the balance of liability component over the life of the loan.
Derivative liability Convertible note with embedded derivative – The numbers
The fair value of the conversion feature would have to be determined at each reporting date and the fair value changes would be recognised in profit or loss. The following table sets out the effect on profit or loss assuming the following fair values at each year end:
Fair value of conversion feature
Profit or (loss) effect
CU (20) 8
Thus, if the conversion feature is classified as a derivative liability, this will often lead to a significantly higher and more volatile expense pattern in trading profit or loss. This is because a derivative liability is remeasured to fair value at each reporting date, whereas if the conversion feature is classified as equity, because if equity classification is met, no re-measurement of the conversion feature is required.