above) leads to the rather counter-intuitive result that the classification of certain
instruments in consolidated financial statements depends on the functional currency of
the issuing entity.
If, in the example in 5.2.3 above, the UK entity’s US subsidiary (with a functional
currency of US dollars) issued the same $100 bond convertible into its own equity,
convertible in turn into the UK parent’s equity, the conversion right would (from the
perspective of the US subsidiary) involve the issue of a fixed number of shares for a
fixed amount of cash and thus be an equity instrument. Moreover, this classification
would not change on consolidation since IFRS has no concept of a group functional
currency (see Chapter 15).
The Interpretations Committee discussed this issue at its meetings in July and
November 2006. Specifically, it was asked to consider whether the fixed stated
principal of the convertible instrument exchanged for equity of the parent on
conversion can be considered ‘fixed’ if it is denominated in the functional currency
of either the issuer of the exchangeable financial instruments (i.e. the US subsidiary
in the example above) or the issuer of the equity instruments (i.e. the UK parent in
the example).
The Interpretations Committee noted that a group does not have a functional currency.
It therefore discussed whether it should add a project to its agenda to address which
currency should be the reference point in determining whether the embedded
conversion options are denominated in a foreign currency. The Interpretations
Committee believed that the issue was sufficiently narrow that it was not expected to
have widespread relevance in practice and therefore, decided not to take the issue onto
its agenda.32
In our view, given the absence of specific guidance, an entity may, as a matter of
accounting policy, determine the classification, in its consolidated financial statements,
of an instrument issued by a subsidiary by reference either to that subsidiary’s own
functional currency or to the functional currency of the parent into whose equity the
bond is convertible.
The effect of this policy choice will be that, where the debt is denominated in a
currency other than the designated reference functional currency, the consolidated
financial statements contain no equity component. This policy, and its
consequences under IAS 32, must be applied consistently, as illustrated by
Example 43.13 below.
Financial instruments: Financial liabilities and equity 3561
Example 43.13: Convertible bond issued by a subsidiary with a functional
currency different to that of the parent
Suppose that a UK entity with a functional currency of the pound sterling (GBP) has a US trading subsidiary
with a functional currency of the US dollar (USD). The US subsidiary issues a bond convertible, at the
holder’s option, into equity of the UK parent.
If the parent’s functional currency (GBP) is the reference currency, the accounting treatment of the holder’s
conversion right in the consolidated financial statements will be as follows:
• if the fixed stated principal of the bond is denominated in GBP: equity (stated principal of bond is fixed
by reference to GBP); but
• if the fixed stated principal of the bond is denominated in a currency other than GBP: derivative (stated
principal of bond is variable by reference to GBP).
If, however, the subsidiary’s functional currency (USD) is the reference currency, a converse analysis applies,
and the accounting treatment of the holder’s conversion right in the consolidated financial statements will be
as follows:
• if the fixed stated principal of the bond is denominated in USD: equity (stated principal of bond is fixed
by reference to USD); but
• if the fixed stated principal of the bond is denominated in a currency other than USD: derivative (stated
principal of bond is variable by reference to USD).
It may be that the Interpretations Committee’s reluctance to issue guidance on this
matter was influenced by the more subtle point that, in most cases, the issuing entity
will not be, as in Example 43.13 above, a trading subsidiary, but rather a subsidiary
created only for the purposes of the bond issue. IAS 21 – The Effects of Changes in
Foreign Exchange Rates – suggests that the functional currency of such a ‘single
transaction’ entity is the same as that of the parent for whose equity the bond will be
exchanged, irrespective of the currency in which the bond is denominated (see
Chapter 15 at 4). In short, the Interpretations Committee was perhaps hinting that the
real problem may be the misapplication of IAS 21 in the financial statements of the
issuing subsidiary rather than the interpretation of IAS 32.
6.6.5
Convertibles with cash settlement at the option of the issuer
As discussed as 5.2.8 above, IAS 32 requires a derivative with two or more settlement
options to be treated as a financial asset or a financial liability unless all possible
settlement alternatives would result in it being an equity instrument. Many convertible
bonds currently in issue contain a provision whereby, if the holder exercises its
conversion option, the issuer may instead pay cash equal to the fair value of the shares
that it would otherwise have been required to deliver. This is to allow for unforeseen
circumstances, such as an inability to issue the necessary number of shares to effect
conversion at the appropriate time.
Where a bond has such a term, the conversion right is a derivative (in effect, a written call
option over the issuer’s own shares) which may potentially be settled in cash, such that
there is a settlement alternative that does not result in it being an equity instrument. This
means that the ‘equity component’ of a bond with an issuer cash settlement option is not
in fact an equity instrument, but a financial liability. The financial reporting implication of
this is that the conversion right must be accounted for as a derivative at fair value, with
changes in value included in profit or loss – in other words the financial statements will
reflect gains and losses based on the movement of the reporting entity’s own share price.
3562 Chapter 43
6.6.6
Bond convertible into fixed percentage of equity
The terms of a convertible bond may allow conversion into a fixed percentage of
outstanding shares of the issuer at the time of the conversion, so that the absolute
number of shares to be issued is not fixed and is not known until conversion occurs.
This raises the question of whether such a clause violates the ‘fixed for fixed’ criterion,
or whether it can be seen as an anti-dilutive mechanism to keep the holder in the same
economic position relative to other shareholders at all times (similarly to bonds whose
conversion ratio is adjusted for changes in share capital, as discussed under 5.1.2 above).
Our view is that such a conversion option cannot normally be classified as equity,
because the entity’s capital structure could change in ways that put the convertible bond
holder into a better economic position relative to other shareholders.
6.6.7
Convertible bonds with down round o
r ratchet features
Some instruments that are convertible at a fixed price have clauses which provide that,
if additional equity is subsequently issued at a price lower than the conversion price,
then the conversion price is amended down to ensure the holders of the convertible
instrument are not economically disadvantaged. These clauses are often called ‘down
round’ or ‘ratchet’ clauses.
When assessing instruments with down round or ratchet clauses it is necessary to know
whether the instrument or component being assessed is a non-derivative or a derivative
instrument. This is because there are two fixed for fixed tests in IAS 32.16(b).
In the case of a non-derivative the test is whether there is a contractual obligation or
not for the issuer to deliver a variable number of its own equity instruments. [IAS 32.16b(i)].
Therefore the ability of the entity to prevent a down round or ratchet clause taking
effect (by choosing not to issue shares at a lower price) is important and where that is
the case the down round or ratchet feature is ignored.
In the case of a derivative instrument or derivative component of an instrument the test is
simply whether it will always be settled by exchanging a fixed number of shares for a fixed
amount of cash or another financial instrument. [IAS 32.16b(ii)]. Therefore the entity’s ability
to prevent the down round or ratchet clause taking effect does not affect the classification.
Example 43.14: Convertible bond with ratchet feature
A company, issues preference shares. The preference shares carry a dividend of 2% discretionary at the option
of the issuer. Preference shareholders have a right to convert the preference shares into ordinary shares if
there is an IPO or earlier if agreed by 60% of the preference shareholders. If not converted, preference shares
are redeemable at par at the end of eight years from the issue date. The conversion ratio is fixed at inception
at one ordinary share for one preference share. However, the ratio is subject to an anti-dilution clause. If the
entity in future issues any new ordinary shares or convertible shares at a price or conversion price lower than
the conversion price of the existing preference shares, the conversion price of the existing preference shares
is adjusted down using a prescribed formula.
The requirement to redeem the issue at par after eight years creates a liability component which would be
extinguished if the conversion option is exercised. As such the presence of the redemption obligation makes
the conversion option a derivative. In this case the fact that the company has control over whether the ratchet
feature is triggered through the issuance of new shares is not relevant. The derivative component cannot be
settled only on a fixed for fixed basis and so the redemption obligation is a liability component.
Financial instruments: Financial liabilities and equity 3563
7
SETTLEMENT OF FINANCIAL LIABILITY WITH EQUITY
INSTRUMENT
Neither IAS 32 nor IFRS 9 specifically addresses the accounting treatment to be
adopted where an entity issues non-convertible debt, but subsequently enters into an
agreement with the debt holder to discharge all or part of the liability in exchange for
an issue of equity. These transactions, which are sometimes referred to as ‘debt for
equity swaps’, most often occur when the entity is in financial difficulties and became
widespread, particularly among highly leveraged entities, following the financial crisis.
The Interpretations Committee noted that divergent accounting treatments for such
transactions were being applied and decided to address this by developing an
interpretation. As a result, IFRIC 19 was published in November 2009. [IFRIC 19.1].
7.1
Scope and effective date of IFRIC 19
IFRIC 19 addresses the accounting by an entity when the terms of a financial liability are
renegotiated and result in the entity issuing equity instruments to a creditor to extinguish all
or part of the financial liability. It does not address the accounting by the creditor. [IFRIC 19.2].
Further, the interpretation does not apply to transactions in situations where: [IFRIC 19.3]
• the creditor is also a direct or indirect shareholder and is acting in its capacity as a
direct or indirect existing shareholder (see 7.3 below);
• the creditor and the entity are controlled by the same party or parties before and
after the transaction and the substance of the transaction includes an equity
distribution by, or contribution to, the entity (see 7.3 below); or
• the extinguishment of the financial liability by issuing equity shares is in
accordance with the original terms of the financial liability. This will most
commonly arise on conversion of a convertible bond that has been subject to ‘split
accounting’, the accounting for which is covered at 6 above.
7.2
Requirements of IFRIC 19
Equity instruments issued to a creditor to extinguish all or part of a financial liability are
treated as consideration paid and should normally be measured at their fair value at the
date of extinguishment. However, if that fair value cannot be reliably measured, the
equity instruments should be measured to reflect the fair value of the financial liability
extinguished. The difference between the carrying amount of the financial liability and
the consideration paid (including the equity instruments issued) should be recognised in
profit or loss and should be disclosed separately. [IFRIC 19.5-7, 9, 11].
These requirements are illustrated in the following simple example.
Example 43.15: Discharge of liability for fresh issue of equity
During 2010 an entity issued £100 million bonds due to be repaid in 2020. By 2018 the entity is in some
financial difficulty and reaches an agreement with the holders of the bonds whereby they will accept equity
shares in the entity in full and final settlement of all amounts due under the bonds. On the date the agreement
concludes, the carrying amount of the bonds is £99 million and the fair value of the equity shares issued is
£60 million.
In this situation the entity would measure the equity instruments issued at their fair value of £60 million and
recognise a profit on extinguishment of £39 million [£99 million – £60 million].
3564 Chapter 43
Debt for equity swaps often take place in situations when the terms of the financial
liability such as covenants are breached and the liability has become, or will become,
repayable on demand. Normally, the fair value of a financial liability with a demand
feature is required by IFRS 13 to be measured at no less than the amount payable on
demand, discounted from the first date that the amount could be required to be paid
(see Chapter 14 at 11.5). However, in the IASB’s view, the fact that a debt for equity
swap has occurred indicates that the demand feature is no longer substantive.
Consequently, where the fair value of the equity instruments issued is based on the
fair value of the liability extinguished, this particular aspect of IFRS 13 is not applied.
[IFRIC 19.7, BC22].
If only part of the financial liability is extinguished, some of the consideration paid might
relate to a modification of the terms of the liability that remains outstanding. If so, the
considera
tion paid should be allocated between the part of the liability extinguished and
the part of the liability that remains outstanding. All relevant facts and circumstances
relating to the transaction should be considered in making this allocation. [IFRIC 19.8]. Any
consideration so allocated forms part of the assessment of whether the terms of that
remaining liability have been substantially modified. If the remaining liability has been
substantially modified, the modification should be accounted for as an extinguishment
of the original liability and the recognition of a new liability in accordance with IFRS 9
(see Chapter 48 at 6.2). [IFRIC 19.10].
7.3
Debt for equity swaps with shareholders
As noted at 7.1 above, a debt for equity swap is outside the scope of IFRIC 19 when the
creditor is a shareholder acting in its capacity as such, or where the entity and the
creditor are under common control and the substance of the transaction includes a
distribution by, or capital contribution to, the entity.
In our view, such transactions may be accounted for either in a manner similar to that
required by IFRIC 19 or by recording the equity instruments issued at the carrying
amount of the financial liability extinguished so that no profit or loss is recognised. This
latter method was in fact commonly applied to debt for equity swaps before the
publication of IFRIC 19.
8
INTEREST, DIVIDENDS, GAINS AND LOSSES
The basic principle of IAS 32 is that inflows and outflows of cash (and other assets)
associated with equity instruments are recognised in equity and the net impact of
inflows and outflows of cash (and other assets) associated with financial liabilities is
ultimately recognised in profit or loss. Accordingly, IAS 32 requires:
• interest, dividends, losses and gains relating to a financial instrument or a component
that is a financial liability to be recognised as income or expense in profit or loss;
• distributions to holders of an equity instrument to be debited directly to equity; and
• the transaction costs of an equity transaction to be accounted for as a deduction
from equity. [IAS 32.35]. This applies also to the costs of issuing equity instruments
that are issued in connection with the acquisition of a business. [IFRS 3.53].
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