Question

1. Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock.
2. And discuss the underlying rationale for the differences you described.

Answer 1

CONVERTIBLE BONDS:

A convertible bond is a fixed-income debt that gives the holder a right to convert the bond into fixed number of shares.

For example, convertible bonds can be converted into shares of 3:1, means that the holder gets 3 shares for every one bond he holds.

As per IFRS, the company issuing the convertible bonds must separately identify the Equity and Debt component of the bond and treat them accordingly in the Financial Statements.

Calculation of Financial Liability (Debt) component and Equity Component:

The present values, calculated by discounting the future cash flows i.e., of the interest and principle at the rate of a similar bond that has no conversion option, gives the liability component i.e., the debt component of the Convertible Bond.

The difference between the proceeds from the issue of the convertible bond and the liability component calculated as stated above is the Equity Component of the Bond.

Later on, Interest is charged to the income statement based on the effective interest rate.

On maturity, if the conversion is exercised, then the company issues the shares to the holders of the bond.

If any holder doesn’t convert the bonds, then the company pays the principal amount of the convertible bond.

DEBT INSTRUMENTS WITH SEPARATE WARRANTS:

Share warrants are instruments that give the holder a right, but not an obligation, to purchase the entity’s shares at specified price (generally at discounted prices) and date.

For example, warrants issued to investors to enable them to purchase additional shares in future at discounted/fixed prices thereby providing additional value to the holder of these warrants.

It gives the warrant holder the right to purchase a set number of shares from the issuer for a given price per share.

The value of the warrant is equal to the difference in the price of the bond trading with warrant and bond trading without the warrant.

Accounting for Debt Instruments with Separate Warrants:

The Debt instruments and share warrants are both separate and hence the accounting treatment fotr them is separately identified.

For Debt instrument, the financial liability is calculated by discounting the present value of the future cash outflows i.e., the interest and principal of the debt instrument.

The warrant holds the separate value in the market and is even tradable.

The value of the Debt iNstrument with the share warrant is the sum of the value of similar debt instrument without warrant and the value of the warrant.

Generally, the company does not have to pay the cash for warrants, instead the company issues shares to the holder of the warrant.

But to classify the warrant as a Equity instrument or the Financial Liability depends on the number of shares to be issued and the price at which they are issued.

If the company can determine the price at which the shares are issued for the warrants and the number of shares to be issued is fixed, then the company classifies the warrants as the Equity Instruments.

If the company is unable to determine the value or the number of shares to be issued and can only be determined at the future date, then the warrants are shown as financial liability.

UNDERLYING RATIONALE:

It is clear evident that the Convertible bonds, conversion option is purely at the option of the investor or holder of the bond.

Also, the Interest and Principle amounts to be paid are fixed and these are to be paid compulsorily irrespective of the holder choosing the option to convert.

Hence a financial liability component is created.

The difference is obvious, will be the equity component.

Further the accounting treatment depends upon the option of the holder to convert the bond or not.

For Debt Instruments with Warrants, it is clear evident that in the future, the warrants will be exercised and the company cannot treat them as a liability. However if the value of the shares is not known, then the company needs to classify them as a liability.