Convertible Notes - Basic Requirements – FAQ | IFRS

Convertible notes – Basic requirements

Convertible notes are financial instruments that fall within the scope of IAS 32 Financial Instruments: Presentation and IFRS 9 Financial Instruments.

IAS 32 contains the definitions of financial liabilities, financial assets and equity. Therefore, whether a financial instrument should be classified as liability or equity is dealt with under IAS 32. As noted above, the standard approach in IFRS requires that a convertible instrument is dealt with by an issuer as having two ‘components’, being a liability host contract plus a separate conversion feature which may or may not qualify for classification as an equity instrument.

The definitions set out in IAS 32 for financial liabilities and equity are detailed and appear complex (see extracts below).

However, for the purposes of accounting for convertible instruments by an issuer they can be summarised in two key principles:

  • Does an entity have a contractual obligation to deliver cash or another financial asset that it cannot avoid? If the entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the obligation meets the definition of a financial liability
  • A financial instrument can only be classified as equity if the ‘fixed-for-fixed’ criterion is met, ‘a contract that will be settle by the entity delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash’ (IAS 32 22) is an equity instrument.

A financial liability is defined under IAS 32 as:

‘…(a) A contractual obligation

  1. to deliver cash or another financial asset to add another entity, or
  2. to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or

(b) A contract that will or may be settled in the entity’s own equity instruments and is:

  1. a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
  2. a derivative that will or may be settled other than by the exchange offered fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non—derivative equity instruments.’ (IAS 32 11).

Where an entity has a contractual obligation to deliver cash or another financial asset or a contract that requires settlement in a variable number of the entity’s own shares, that contract is a financial liability. A key criterion for liability classification is when the entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation (IAS 32 19).

IAS 32 defines equity ‘any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities’ (IAS 32 11). The definition of an equity instrument is the opposite of the financial liability definition above:

‘…(a) The instrument includes no contractual obligation

  1. to deliver cash or another financial asset to another entity; or
  2. to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer.

(b) If the instrument will or may be settled in the issuer’s own equity instruments, it is:

  1. a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or
  2. a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments.…’ (IAS 32 16).

The following flow chart summarises the accounting requirements in IAS 32 in relation to the evaluation of liability and equity classification of financial instruments.

Liability and equity classification in IAS 32/IFRS 9:

Convertible notes - Basic requirements Convertible notes - Basic requirements

Once the appropriate classification of a financial instrument has been determined (including, where applicable – such as for certain convertible instruments – identification of the liability and equity components), it is then necessary to determine the measurement of the individual components.

Compound instrument

When a convertible instrument has been determined to contain a host liability and embedded equity conversion feature, the fair value of the liability component is determined first. This is established by using a present value calculation, i.e. the contractual stream of future cash flows is discounted at the rate of interest that would apply to an identical financial instrument without the conversion option (that is, a stand-alone loan or debt instrument). The equity component is then assigned as the residual amount, by deducting the amount calculated for the liability component from the fair value of the instrument as a whole. This is consistent with the definition of equity under which an equity instrument is a residual interest. See this example for a calculation of these three components.

Convertible notes - Basic requirements Convertible notes - Basic requirements

Liability

Liability initial measurement at fair value and subsequent measurement as per IFRS 9 paragraphs 4.2.1–4.2.2.

Equity

Equity is measured as the residual interest in the assets of the entity after deducting all its liabilities.

Leave a comment