COMPOUND FINANCIAL INSTRUMENTS

Financial Instrument
A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity
instrument of another entity (par 11, PAS 32). Examples of financial instruments are provided in the ensuing table:

Particulars *Financial asset (FA) Financial liability (FL) Equity instrument (EI)
Cash in the form of notes and coins FA (cash) of the holder/ bearer FL of the issuing government -
Cash in the form of checks FA (cash) of the payee FL of the drawer/ issuer -
Cash in bank FA (cash) of the depositor FL (deposit liabilities) of the
-
depository bank
Trade accounts FA (accounts or notes receivable) FL (accounts or notes payable) of
-
of the seller the customer
Notes and loans FA (notes or loans receivable) of FL (notes or loans payable) of the
-
the lender/creditor borrower/debtor
Debt securities FA (investment) of the investor FL of the issuer/investee (e.g.
-
(e.g. investment in bonds) bonds payable)
Equity securities FA of the investor (e.g. investment EI of the issuer (e.g. ordinary
-
in ordinary shares) shares and preference shares)
* No discussion is made on financial assets since this topic is covered under FAR 1

Financial liability
A financial liability is any liability that is a contractual obligation to: (1) deliver cash or other financial asset to another entity;
or (2) exchange financial instruments with another entity under conditions that are potentially unfavorable. Typical examples
of financial liabilities include trade accounts payable, notes payable, loans payable and bonds payable. Liabilities such as
deferred revenue, warranty obligations, income tax payable and constructive obligations are not classified as financial
liabilities since they do not satisfy the very definition of liabilities of this type.

Equity instrument
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of the
liabilities. Typical examples of equity instruments include ordinary share capital, preference share capital and warrants or
options that allow the holder to buy such shares.

Compound financial instrument

A compound financial instrument is a financial instrument that contains both a liability and an equity element from the
perspective of the issuer (par. 28, PAS 32). Typical examples of compound financial instruments include (1) bonds payable
issued with share warrants and (2) convertible bonds payable.

Accounting procedures for compound financial instrument:

1. The consideration received from the issuance of the compound financial instrument shall be allocated between the liability
and equity components (“split accounting”).
2. Priority in measurement is given to the liability component which is measured at fair value.
3. The difference between the consideration received and the fair value assigned to the liability component is then attributed
to the equity component, it being residual in nature (Item No. 1 – Item No. 2).

Bonds issued with share warrants

Bonds issued with share warrants (detachable or not) give the holder the right to acquire shares of the issuing entity at a
specified price at some future determinable time.

Allocation of issue price:

1. The bonds (liability component) are assigned an amount equal to the “market value of the bonds, ex-warrants”, without
regard to the market value of the share warrants.
2. The residual amount of the issue price or consideration received shall then be allocated to the share warrants (equity
component).
3. If the market value of the bonds ex-warrants is unknown, the fair value assigned to the bonds shall be equal to the present
value of the principal bond liability plus the present value of the future interest payments using the effective or market
interest rate for similar bonds without the warrants (see discussions on market price of bonds in prior handout).

Exercise of warrants
Upon exercise of the warrants by the holders, any excess of the sum of the cash received and the cost of the warrants exercised
over the par value of the shares issued is credited to share premium – issuance account. Any cost of warrants not exercised
must be credited to share premium – unexercised warrants account.
COMPOUND FINANCIAL INSTRUMENTS

Convertible bonds
Convertible bonds give the holders the right to convert their bondholdings into share capital or other securities of the issuing
entity within a specified period of time.

Allocation of issue price:

1. The bonds (liability component) are assigned an amount equal to the market value of the bonds without the conversion
privilege.
2. The residual amount of the issue price or consideration received shall then be allocated to the conversion privilege (equity
component).
3. If the market value of the bonds without the conversion privilege unknown, the fair value assigned to the bonds shall be
equal to the present value of the principal bond liability plus the present value of the future interest payments using the
effective or market interest rate for similar bonds without the conversion privilege (see discussions on market price of
bonds in prior handout).

Conversion of bonds
The carrying amount of the bonds is the measure of the share capital to be issued at the time of conversion because the
carrying amount is deemed as the “effective price” for the shares issued as a result of the conversion. The excess of the
computed carrying amount of the bonds converted over the par value of the shares issued is credited to share premium –
issuance account. The same account is debited for any costs incurred in connection with the conversion.

Specific accounting procedures on conversion:

1. The amortization of discount, issue cost or premium shall be recorded up to the date of conversion.
2. The face amount of the bonds converted; along with the proportionate (if only a portion of the bonds is converted)
discount, issue cost or premium related to the said bonds, shall be cancelled or derecognized.
3. If conversion is made at an interest date (which is the normal case), any interest on that date is paid and charged to interest
expense. However, if interest is unpaid as at the time of conversion, the same is charged to interest expense and is added
to the carrying amount of the bonds for conversion purposes.

PRO – FORMA ENTRIES

BONDS PAYABLE ISSUED WITH SHARE WARRANTS CONVERTIBLE BONDS
Cash xx Cash xx
Discount on bonds payable xx Discount on bonds payable xx
Bonds payable xx Bonds payable xx
Share warrants outstanding xx Share premium – conversion privilege xx
Entry to record the issuance of the bonds at a discount, with warrants Entry to record the issuance of convertible bonds at a discount

Cash xx Bonds payable xx

Share warrants outstanding xx Discount on bonds payable xx
Share capital xx Share capital xx
Share premium – issuance xx Share premium – issuance xx
Entry to record the exercise of the share warrants Entry to record the exercise of the conversion privilege

Share warrants outstanding xx Share premium – conversion privilege xx

Share premium – unexercised warrants xx Share premium – unexercised privilege xx
Entry to cancel unexercised, expired warrants Entry to cancel unexercised, expired conversion privilege

Payment of convertible bonds

PAYMENT OF CONVERTIBLE BONDS AT MATURITY PAYMENT OF CONVERTIBLE BONDS BEFORE MATURITY

Bonds payable xx Bonds payable xx
Interest expense xx Share premium – conversion privilege xx
Cash xx Discount on bonds payable xx
Entry to record the payment of the convertible bonds at maturity. Note Cash Xx
that the entry does not include any discount, issue cost or premium, Entry to record the payment of convertible bonds prior to maturity.
since the same, if any, are presumed to have been fully amortized as at Note that the payment is allocated between the liability and the equity
maturity - payment date. components. Accordingly, a gain or loss on extinguishment of debt is
recognized at the time of payment.

Share premium conversion privilege xx Share premium conversion privilege xx

Share premium – unexercised privilege xx Share premium – unexercised privilege Xx
Entry to cancel the unexercised conversion privilege at the time of Entry to cancel the balance of the conversion privilege not covered by
payment. the payment.
*Note that under the 2 illustrated cases, interest is presumed to have been paid at the time of payment of the convertible bonds.