What Is a Compound Financial Instrument?
A compound financial instrument is a single instrument that contains both a financial liability and an equity instrument. The standard example is a convertible bond: the issuer must pay interest and, if the holder does not convert, repay the capital (a liability), while the holder may instead exchange the bond for a fixed number of the issuer's shares (equity).
IAS 32 Financial Instruments: Presentation requires the issuer to account for the two parts separately, a process known as split accounting (IAS 32.28 to .32):
- Measure the liability component at the present value of the contractual cash flows, discounted at the market rate for similar debt without the equity feature.
- Recognise the equity component as the residual: proceeds less the liability component.
- Measure the liability at amortised cost using the effective interest method under IFRS 9. The equity component is not remeasured.
The result is that interest expense reflects a market rate of borrowing, not the lower coupon that holders accept in exchange for the right to convert.
Liability or Equity: The Classification Tests
An issuer classifies an instrument, or each of its components, according to its substance rather than its legal form (IAS 32.15 and .18). A preference share can be a liability; a bond can contain equity.
A financial liability exists where the issuer has a contractual obligation it cannot avoid to deliver cash or another financial asset. Coupons the issuer must pay and capital it must repay are liabilities.
An equity instrument evidences a residual interest in the net assets. The issuer has no obligation to pay, and any settlement in its own shares must meet the fixed-for-fixed test: a fixed number of shares exchanged for a fixed amount of cash or a fixed financial liability (IAS 32.16 and .22).
Each cash flow of an instrument is tested against these definitions, over its life and at the end of its life:
- During its life: are interest or dividend payments compulsory (liability) or at the issuer's discretion (equity)?
- At the end of its life: must the issuer repay cash (liability), or is it settled by issuing a fixed number of shares (equity)?
Where the answers point in different directions, the instrument is compound.
Probability does not change the classification
Classification is not revised when conversion becomes more or less likely, for example after a rise in the share price (IAS 32.30). The split made at initial recognition stands until the instrument is converted, redeemed or otherwise derecognised.
Key Examples of Compound Instruments
| Instrument | Liability component | Equity component |
|---|---|---|
| Bond convertible into a fixed number of shares at the holder's option | PV of coupons and the redemption amount | Holder's option to convert |
| Bond mandatorily convertible into a fixed number of shares, with compulsory coupons | PV of coupons only | Obligation to deliver a fixed number of shares at maturity |
| Bond convertible at the issuer's option into a fixed number of shares | PV of coupons only (the issuer can avoid repaying the capital by converting) | Settlement of the capital in shares |
| Preference shares mandatorily redeemable in cash, with discretionary dividends | PV of the redemption amount | Discretionary dividends |
| Preference shares with compulsory dividends, convertible into a fixed number of ordinary shares at the holder's option | PV of dividends and any redemption amount | Holder's option to convert |
The table also shows why the settlement option matters. When the holder chooses whether to convert, the issuer cannot avoid repaying the capital, so the redemption amount forms part of the liability. When conversion is compulsory, or at the issuer's option, only the coupons are an unavoidable obligation.
Several instruments that resemble convertibles are not compound:
- Conversion into a variable number of shares, such as shares worth 1,000,000 at the conversion date. This fails fixed-for-fixed; the whole instrument is a financial liability.
- Conversion options that can be settled net in cash, or where either party can choose a settlement alternative that is not equity (IAS 32.26). The option is a derivative liability.
- Conversion into shares for a fixed amount of a foreign currency. Outside the narrow rights issue exception in IAS 32.16(b)(ii), the amount is not fixed in the issuer's functional currency, and the option is a derivative liability.
Splitting the Liability and Equity Components
IAS 32.31 and AG31 set out the residual method:
- Identify the unavoidable cash flows: compulsory coupons or dividends, plus the redemption amount where the issuer cannot avoid paying it.
- Determine the discount rate: the market rate at issue for an instrument with comparable credit standing and similar cash flows, but without the conversion feature.
- Discount the cash flows: the present value is the liability component. Any embedded non-equity derivatives, such as an issuer call option, are included in the liability component (IAS 32.31).
- Calculate the residual: proceeds less the liability component is the equity component.
Because the two components together equal the fair value of the whole instrument (usually the transaction price), no gain or loss arises on initial recognition. The same present value mechanics apply when calculating a lease liability under IFRS 16.
Practical Example: Convertible Bond
On 1 January 20X1, a company issues 20,000 bonds at 100 each, raising 2,000,000. The bonds carry a coupon of 6% (120,000 a year), payable annually in arrears, and mature on 31 December 20X3. At maturity each holder may redeem at par or convert each bond into 25 ordinary shares. Similar bonds without a conversion option would yield 10%.
Step 1: Liability component. The holder chooses whether to convert, so the redemption amount is unavoidable and forms part of the liability.
| Cash flow | Amount | PV at 10% |
|---|---|---|
| Coupons (120,000 for 3 years) | 360,000 | 298,422 |
| Redemption at the end of year 3 | 2,000,000 | 1,502,630 |
| Liability component | 1,801,052 | |
| Proceeds | 2,000,000 | |
| Equity component (residual) | 198,948 |
Step 2: Initial recognition.
| Account | Debit | Credit |
|---|---|---|
| Bank | 2,000,000 | |
| Convertible bond liability | 1,801,052 | |
| Equity: convertible bond reserve | 198,948 |
Step 3: Subsequent measurement. The liability is carried at amortised cost. Interest is recognised at 10%, while only 6% is paid, so the liability accretes to 2,000,000 by maturity.
| Year | Opening balance | Interest at 10% | Coupon paid | Closing balance |
|---|---|---|---|---|
| 20X1 | 1,801,052 | 180,105 | (120,000) | 1,861,157 |
| 20X2 | 1,861,157 | 186,116 | (120,000) | 1,927,273 |
| 20X3 | 1,927,273 | 192,727 | (120,000) | 2,000,000 |
Each year the entry is a debit to finance costs for the interest, a credit to bank for the coupon, and a credit to the liability for the difference. Total finance costs over the term are 558,948: the 360,000 of coupons plus the 198,948 equity component. The bond reserve is not touched until the bond is settled.
If the bond were mandatorily convertible into 500,000 shares, the redemption amount would not be an obligation. The liability component would be only the present value of the coupons (298,422) and the equity component 1,701,578.
Transaction Costs
Transaction costs, such as underwriting and legal fees, are allocated to the two components in proportion to the allocation of the proceeds (IAS 32.38).
Continuing the example, the company incurs transaction costs of 50,000:
- Liability: 50,000 × 1,801,052 / 2,000,000 = 45,026
- Equity: 50,000 × 198,948 / 2,000,000 = 4,974
The equity portion is deducted directly from the bond reserve. The liability portion reduces the liability to 1,756,026, which increases the effective interest rate. The rate is recalculated as the rate that discounts the coupons and redemption amount to 1,756,026: approximately 10.99%.
| Year | Opening balance | Interest at 10.99% | Coupon paid | Closing balance |
|---|---|---|---|---|
| 20X1 | 1,756,026 | 193,007 | (120,000) | 1,829,033 |
| 20X2 | 1,829,033 | 201,031 | (120,000) | 1,910,064 |
| 20X3 | 1,910,064 | 209,936* | (120,000) | 2,000,000 |
*Includes a rounding adjustment of 1.
The liability's share of transaction costs is therefore recognised in profit or loss over the term as part of the effective interest, not as an expense on issue.
Conversion, Redemption and Early Settlement
Conversion at maturity. The carrying amount of the liability, 2,000,000, is transferred to equity. No gain or loss is recognised (IAS 32.AG32).
| Account | Debit | Credit |
|---|---|---|
| Convertible bond liability | 2,000,000 | |
| Share capital | 2,000,000 |
The bond reserve of 198,948 remains in equity. The company may transfer it to share capital, but it is never recycled to profit or loss.
Redemption at maturity. The liability is settled in cash (debit liability, credit bank, 2,000,000). The bond reserve again remains in equity, and may be transferred to retained earnings.
Early repurchase or redemption. The consideration paid, and any transaction costs, are allocated between the two components using the same method as at initial recognition, based on fair values at the repurchase date (IAS 32.AG33 and AG34):
- The difference between the amount allocated to the liability and its carrying amount is a gain or loss in profit or loss.
- The amount allocated to the equity component is recognised in equity.
Induced conversion. If the issuer amends the terms to encourage early conversion, for example with a better conversion ratio, the difference between the fair value of what holders receive under the revised terms and under the original terms is a loss in profit or loss at the date the terms are amended (IAS 32.AG35).
Deferred Tax on the Equity Component
Tax law usually treats a convertible bond as debt in its entirety. In South Africa, for example, section 24J applies to the full proceeds, so the tax base of the liability is 2,000,000, while its carrying amount is 1,801,052.
The difference of 198,948 is a taxable temporary difference. The initial recognition exemption does not apply, because it arises from recognising an equity component separately rather than from the initial recognition of an asset or liability (IAS 12.23). At a tax rate of 27%:
- On issue: a deferred tax liability of 53,716 is recognised, debited directly to equity (IAS 12.61A), so the bond reserve is presented net at 145,232.
- Subsequently: the difference reverses as the liability accretes towards 2,000,000, and the movement in the deferred tax liability is recognised in profit or loss.
For compound preference shares, dividends are typically not deductible and the redemption amount is not taxable, so the difference is permanent and no deferred tax arises. The finance cost on the liability component then appears as a reconciling item in the tax rate reconciliation. The underlying principles are set out in our guide to deferred tax.
The Holder's Perspective
Split accounting applies only to the issuer. The holder of a convertible bond accounts for its investment under IFRS 9 and does not separate an equity component.
Because the return depends partly on the issuer's share price, the cash flows are not solely payments of principal and interest. The investment therefore fails the amortised cost criteria and is measured at fair value through profit or loss in its entirety. IFRS 9 does not permit embedded derivatives to be separated from financial asset hosts.
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Conclusion
A compound financial instrument is split according to its contractual terms. Unavoidable obligations to pay cash are measured as a liability at the market rate for comparable debt, and the residual, typically a conversion option into a fixed number of shares, is equity. The liability then accretes at the effective interest rate, which reflects any transaction costs allocated to it, while the equity component remains unchanged until the instrument is settled.
The same present value and amortised cost principles underpin lease accounting. See our guide to calculating the lease liability under IFRS 16.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.