acct334.intermediate.financial.accounting | term2.

2023-24

03 FINANCIAL LIABILITIES & EQUITY

Andrew Lee

© 2023-2024 Andrew Lee.

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 Definition and classification of financial liabilities

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 Definition of financial liability—SFRS(I) 1-32

SFRS(I) 1-32:11 – A financial liability is any liability that is:

n A contractual obligation to deliver cash or another financial asset to
another entity
w E.g. Trade payables, Loan payable, Bond payable
n A contractual obligation to exchange financial assets or liabilities with
another entity under conditions that are potentially unfavorable to the
entity
Derivatives
w E.g. Written options that are in-the-money for the option holder; Unrealized
loss exposures on forward contracts
n A contract to deliver a variable quantity of the entity’s own equity
under certain conditions

Writer of the option is the seller of the option

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 Classification criteria flowchart for financial liabilities

No SFRS(I) 9:Appendix A
Is liability held
for trading?
A liability is held for trading
Yes if:
Did entity elect • it is held principally for the
Typically refers
to derivatives fair value purpose of selling or
Yes option (FVO)? repurchasing it in the near
term;
No • it is part of a portfolio
managed with recent actual
pattern of short-term profit-
taking; or
Amortized • it is a derivative (unless
FVTPL
Cost
hedge accounting applies)

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 Accounting classification for financial liabilities
SFRS(I) 9:4.2.1-4.2.2 –
Classification is based on mandatory criteria, not on choice.

Classification Initial Subsequent Subsequent

recognition measurement recognition

Amortized Fair value* minus Amortized cost Interest expense to P&L

Cost transaction costs# (using effective interest rate
method)

FVTPL Fair value* Fair value FV changes to P&L:

(transaction costs are • Except for FV changes
expensed to P&L attributable to changes in
immediately) own credit risk—to OCI
without recycling.
*Fair value on initial recognition assumed equal to consideration exchanged.
#
Transaction costs are deducted from fair value on initial recognition under Amortized Cost but expensed to P&L
immediately under FVTPL—see SFRS(I) 9:5.1.1.

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 Illustration 3.1: Accounting for loan liability at amortized cost

On 31 Dec 20X1, an entity borrowed the following loan from a bank:

Terms of loan
Principal amount $100,000 $
$5,000 $100,000
Interest rate 5.00% ! !
+
1 + 𝐸𝐼𝑅 1 + 𝐸𝐼𝑅 $
Interest period Annual !"#

Interest per period $5,000

= $100,000 − $2,500 = $97,500
Drawdown date 31/12/20X1
Maturity date 31/12/20X6
Maturity 5 years or:
Principal
repay at Using financial calculator
Repayment Bullet the last [n = 5, PMT = $5,000,
Fair value on drawdown $100,000 day
PV = − $97,500, FV = $100,000]
Transaction costs $2,500
Loan discount $2,500 Annual EIR = 5.5868%
Annual EIR 5.5868%

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 Illustration 3.1: Accounting for loan liability at amortized cost

Loan Amortization Schedule (rounded to nearest $):

Date Cash Effective Amortization Unamortized Nominal Gross
interest interest of loan loan amount of carrying
paid expense discount discount loan amount of
@ 5% @ 5.5868% loan
31/12/20X1 0 0 0 $ (2,500) $ 100,000 $ 97,500
31/12/20X2 $ 5,000 $ 5,447 $ (447) (2,053) 100,000 97,947
31/12/20X3 5,000 5,472 (472) (1,581) 100,000 98,419
31/12/20X4 5,000 5,499 (499) (1,082) 100,000 98,918
31/12/20X5 5,000 5,526 (526) (556) 100,000 99,444
31/12/20X6 5,000 5,556 (556) 0 100,000 100,000

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 Illustration 3.1: Accounting for loan liability at amortized cost

31/12/20X1 Dr. Cash $ 97,500

Dr. Loan payable—Unamortized discount 2,500
Cr. Loan payable—Nominal amount $ 100,000
31/12/20X2 Dr. Interest expense (P&L) 5,447
Cr. Loan payable—Unamortized discount 447
Cr. Cash 5,000
31/12/20X3 Dr. Interest expense (P&L) 5,472
Cr. Loan payable—Unamortized discount 472
Cr. Cash 5,000
31/12/20X4 Dr. Interest expense (P&L) 5,499
Cr. Loan payable—Unamortized discount 499
Cr. Cash 5,000
31/12/20X5 Dr. Interest expense (P&L) 5,526
Cr. Loan payable—Unamortized discount 526
Cr. Cash 5,000
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 Illustration 3.1: Accounting for loan liability at amortized cost

31/12/20X6 Dr. Interest expense (P&L) $ 5,556

Cr. Loan payable—Unamortized discount $ 556
Cr. Cash 5,000
Dr. Loan payable—Nominal amount 100,000
Cr. Cash 100,000

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 The fair value option (FVO) – SFRS(I) 9:4.2.2

Even if a liability would be classified under amortized cost, an entity can

elect to classify that liability under FVTPL – a.k.a. fair value option –
subject to the following conditions:
n Election to be made on initial recognition and is irrevocable.
n Election made only so as to eliminate or significantly reduce a measurement or
recognition inconsistency (a.k.a. an accounting mismatch), thereby providing
more relevant information in financial statements.
w Certain assets and liabilities may share a common risk (e.g., interest rate risk)
that gives rise to opposite and offsetting impact, but they are not accounted for
under the same bases—e.g., assets are measured at FVTPL, while liabilities are
measured at amortized cost.
n The liability is part of a portfolio managed and evaluated on a fair value basis (e.g.,
trading portfolio).

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 Distinguishing between financial liability and equity

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 What constitutes a financial liability vs. equity?

SFRS(I) 1-32:15 – The issuer of a financial instrument shall classify the

instrument, or its component parts, on initial recognition as a financial
liability, a financial asset or an equity instrument in accordance with the
substance of the contractual arrangement and the definitions of a
financial liability, a financial asset and an equity instrument.

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 What constitutes a financial liability vs. equity?

SFRS(I) 1-32:11 –

A financial liability is any liability that is:

n A contractual obligation to deliver cash or another financial asset to another
entity
n A contractual obligation to exchange financial assets or liabilities with another
entity under conditions that are potentially unfavorable to the entity
n A contract to deliver a variable quantity of the entity’s own equity under
certain conditions

An equity instrument is any contract that evidences a residual interest in the

assets of an entity after deducting all its liabilities.

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 What constitutes an equity instrument?

SFRS(I) 1-32:16 – (An) instrument is an equity instrument if and only if

all of the following conditions are met:
n The instrument includes no contractual obligation:
w to deliver cash or another financial asset to another entity; or
w to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavorable to the issuer.
n If the instrument will or may be settled in the issuer’s own equity instruments,
it is:
w a non-derivative that includes no contractual obligation for the issuer to
deliver a variable number of its own equity instruments; or
w 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.

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 Classification flowchart for financial liability vs. equity
Yes
Contractual obligation to deliver cash or
another financial asset to another entity?

No Yes
Contractual obligation to exchange financial assets
or liabilities under potentially unfavorable conditions?

No
Contractual No A derivative? Yes Will be settled only
obligation to deliver a by entity issuing a
variable number of fixed number of its
entity’s own shares? Yes own shares?
Yes
No No
When number of entity’s own shares delivered/issued is
fixed (variable), the equity holder (entity) bears equity
price risk, hence instrument is equity (liability) to entity.

Equity Liability

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 Instruments that require entity to issue shares

When an instrument requires an entity to issue its own shares

(whether by settlement or under a contractual obligation),
is the instrument equity or liability to the entity?

When no. of its own …then equity price …in which case, the
shares issued by risk is borne by: entity/issuer recognizes
entity is: the instrument as:

Fixed Equity holder Equity

Variable Entity Liability

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 Puttable financial instruments

SFRS(I) 1-32:16A – A puttable financial instrument includes a

contractual obligation for the issuer to repurchase or redeem that
instrument for cash or another financial asset on exercise of the put.

A puttable financial instrument is therefore a financial liability of the

issuer, unless the put occurs only in the event of the entity’s
liquidation and the holders are entitled only to a pro rata share of the
entity’s net assets (i.e. the holders bear equity price risk).

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 Illustration 3.2 – Examples of financial liability/equity

Financial instrument Liability or Equity to entity?

Ordinary shares. Entity issues one Equity. Entity
Equity, has
entity has nono obligation
obligation to
to pay cash
or to other financial asset,
million of its own ordinary shares to pay Number
cash or otherfixed
of shares financial asset.
investors at $1 per share. Number of shares fixed.
Non-cumulative non-redeemable Equity. Entity has no obligation to
Equity, entity has no obligation to pay
dividends or other financial asset.
preference shares. Entity issues one pay dividends
Preference orare
shares other financial
non redeemable.
Priority ranking does not negate equity risk
million preference shares with non- asset. Preference
of preference shares are non-
shareholders.
cumulative preference dividend of 5% redeemable. Priority ranking does
p.a. Preference shares not redeemable, not negate equity risk of
but rank senior to ordinary shares in preference shareholders.
winding-up.
Share warrants. Entity issues one Equity. Share warrants are
million warrants to investors at $0.20 derivative instruments. Number of
each. Each warrant holder has the right shares
Equity,issued (when
fixed share
to pay cash
warrants
price and are
no obligation

to buy one ordinary share in the entity for exercised) is fixed.

$1 per share.

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 Illustration 3.2 – Examples of financial liability/equity

Financial instrument Liability or Equity to entity?

Cumulative preference shares Liability. Entity has obligation to
redeemable by holder. Entity issues payLiability,
dividends. If obligation
entity has holderstoopt
pay to
dividends, if holders opt to redeem, entity
one million preference shares with redeem,
must payentity musthave
cash. holders paynocash.
equity risk
cumulative preference dividend of 5% Holders have no equity risk.
p.a. Preference shares are redeemable
for cash at holders’ option.
Preference shares redeemable by Equity. Entity has no obligation to
Equity, entity has no obligation to pay
entity. Entity issues one million pay dividends.
dividends. Entity canEntity can to
avobligation avoid
redeem shares.
preference shares with non-cumulative obligation to redeem shares.
preference dividend of 5% p.a. Holders carry
Holders carry equity
equity risk. risk.
Preference shares are redeemable for
cash at entity’s option.

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 Illustration 3.2 – Examples of financial liability/equity

Financial instrument Liability or Equity to entity?

Preference shares with mandatory Liability. Entity has obligation to
redemption. Preference shares pay 5% redeem
Liability,on maturity
entity date.to Holders
has obligation redeem on
dividend and are redeemable for cash carry no equity risk.
maturity date. Holders carry no equity risk
mandatorily on pre-determined date. SFRS(I) 1-32:18(a).

Perpetual capital notes. Entity issues Liability. Entity has obligation to

$1 million par value of notes which carry pay interest every year.
Liability, entity has obligation to pay
interest at 5% p.a. in perpetuity, with no SFRS(I) 1-32:AG6.
interest every year
repayment of principal.

Contract settled with variable number Liability. Entity has obligation to

of shares. Entity purchases gold worth deliver shares
Liability, worth
entity has $1 million
obligation to deliver in
shares worth 1 million in fixed value. entity
$1 million payable in the entity’s own fixed value.
assumes Entity
equity price (instead
risk. of the
shares of a quantity equivalent in value seller) assumes equity price risk.
to $1 million.

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 Illustration 3.3A: DBS 4.7% Non-Cumulative Non-Convertible
Perpetual Capital Securities First Callable in 2019
Terms of
Security
(Source:
DBS Group
Annual Report
2015)

The instrument is equity. It is callable only at the issuer’s option. Distributions are non-
cumulative and may be cancelled at the issuer’s option. That distributions are ranked
ahead of ordinary share dividends does not negate its equity feature.
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 Illustration 3.3B: Singapore Airlines 10-year zero-coupon
mandatory convertible bond
Terms of convertible bond As the bond carries no coupon and is mandatorily
convertible into ordinary shares on maturity, Singapore
Nominal amount $3,496.1 million Airlines has no contractual obligation whatsoever to
Coupon Zero-coupon pay interest or principal to the convertible bondholders.
Issue date 8 Jun 2020 Singapore Airlines has the sole discretion to redeem the
Maturity date 8 Jun 2030 bond, in whole or in part, in cash before maturity for an
Maturity 10 years effective annual yield of 4% during the first 4 years, 5%
during the next 3 years, and 6% during the last 3 years.
Issue price Par
The convertible bond is therefore classified as equity
Conversion option Mandatory
on the balance sheet of Singapore Airlines.
Conversion ratio 1,304.6 million
ordinary shares in
Singapore Airlines
Conversion price
equivalent $2.68 per share
Share price on
issue date $4.29 per share
Source: Singapore Airlines Annual Report 2021.

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 Statements of financial position
Illustration 3.3C: Hyflux AsPerpetual Capital Securities
at 31 December 2015

Group Compa

Terms of Security Notes to the financial statements

Note 2015 2014 2015
(Source: Hyflux Annual Report 2015) $’000 $’000 $’000
Financial guarantee contracts are accounted for as insurance contracts and treated as contingent liabilities until
Equity
such time as they become probable that the Company will be required to make a payment under the guarantee. A
ts. provision is recognised based on the Group’s estimate of the ultimate
Share capital cost of settling all claims
607,258 incurred but unpaid
607,258 607,258
at the balance sheet date. The provision is assessed by reviewing individual claims and tested for adequacy by
Perpetualthe
comparing capital
amountsecurities 469,096to settle the guarantee
recognised and the amount that would be required 469,096 contract. 469,096
excluded whilst bank overdrafts that are repayable
ement are included in cash and cash equivalents. Reserve for own shares (85,929) (61,936) (85,929)
Share capital
Capital reserve 13,731 10,043 8,863
Foreign shares
Ordinary currency translation reserve 469 14,029 –
ession arrangement when it has an unconditional Hedging reserve (15,285) (29,728) 1,277
t the direction of the grantor for the construction Ordinary shares are classified as equity. Incremental costs directly attributable to the issue of ordinary shares and
Employees’ share option reserve 25,069 24,755 25,069
fair value upon initial recognition. Subsequent to share options are recognised as a deduction from equity, net of any tax effects.
st. Retained earnings 273,059 303,664 148,050
Preference share
Total equity capital
attributable to owners
cial asset and partly by an intangible asset, then of the Company 1,287,468 1,337,181 1,173,684 1
and is recognised initially at the fair value of the Preference share capital is classified as equity as it is non-redeemable, or redeemable only at the Company’s option,
Non-controlling
and any dividends areinterests
discretionary. Discretionary dividends thereon 13,383 4,807 within equity –
are recognised as distributions
The instrument is Totalapproval
upon equityby the Board of Directors. 20 1,300,851 1,341,988 1,173,684 1
equity. The perpetual Perpetual capital securities
ted liabilities on the date securities have no
that they are originated.
ess combination are recognised at the acquisition The perpetual capital securities do not have a maturity date and the Company is able to elect to defer making a
t fair value through profitmaturity, and the
or loss) are recognised distribution subject to the terms and conditions of the securities issue. Accordingly, the Company is not considered
issuer hasof option
mes a party to the contractual provisions the to to have a contractual obligation to make principal repayments or distributions in respect of its perpetual capital
securities issue and the perpetual capital securities are presented within equity. Distributions are treated as
defer dividends. dividends which will be directly debited from equity. Costs directly attributable to the issue of the perpetual capital
gations are discharged, cancelled or expired. securities are deducted against the proceeds from the issue.

ed in Andrew Leeof financial position when, and

the statement Repurchase, disposal and reissue of share capital (treasury shares) 23
 Treatment of interest, dividends, gains and losses
—SFRS(I) 1-32:35-41, AG37

SFRS(I) 1-32:35 – Interest, dividends, losses and gains relating to a financial

instrument or a component that is a financial liability shall be recognized as
income or expense in profit or loss. Distributions to holders of an equity
instrument shall be recognized by the entity directly in equity. Transaction costs of
an equity transaction shall be accounted for as a deduction from equity.
Therefore,
n if an instrument is a liability, distributions to holders are regarded as interest
expenses (or finance costs) to be recognized in the income statement.
n If an instrument is equity, distributions to holders are regarded as dividends to
be recognized in the statement of changes in equity.

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 Contingent settlement provisions

SFRS(I) 1-32:25 – A financial instrument may require the entity to deliver cash or
another financial asset … in the event of the occurrence or non-occurrence of
uncertain future events ... that are beyond the control of both the issuer and the
holder of the instrument, such as a change in the stock market index, consumer
price index, interest rate or taxation requirements, or the issuer’s future revenues,
net income or debt-to-equity ratio.
The issuer of such an instrument does not have the unconditional right to avoid
delivering cash or another financial asset. Therefore, it is a financial liability of the
issuer … unless:
n the contingency is not genuine (e.g. it is extremely unlikely to occur – see
SFRS(I) 1-32:AG28), or
n the issuer can be required to settle the obligation in cash or another financial
asset ... only in the event of liquidation of the issuer.

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 Settlement alternatives

SFRS(I) 1-32:26 – When a derivative financial instrument gives one party a choice
over how it is settled (e.g., the issuer or the holder can choose settlement net in
cash or by exchanging shares for cash), it is a financial asset or a financial liability
unless all of the settlement alternatives would result in it being an equity
instrument. Non of the alternative can be cash

E.g., A share option where the issuer can choose to settle net in cash or by
exchanging its own shares for cash.
n The cash settlement alternative renders this instrument a liability, even if the
share settlement alternative involves a fixed number of shares.
n Note that it does not depend on who can choose the settlement alternative
(issuer or holder), or which settlement alternative is likely.

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 Embedded Derivatives, Hybrid Instruments
and Compound Financial Instruments

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 What is an embedded derivative?

SFRS(I) 9:4.3.1 – An embedded derivative is a component of a

hybrid contract that also includes a non-derivative host – with the
effect that some of the cash flows of the combined instrument vary
in a way similar to a stand-alone derivative.
(E.g., convertible bonds)

…
A derivative that is attached to a financial instrument but is
contractually transferable independently of that instrument, or has a
different counterparty, is not an embedded derivative but a separate
financial instrument.
(E.g., Bonds with detachable warrants)

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 What is a hybrid instrument or contract?

Hybrid instrument or contract

Embedded derivative
Host contract (must not be contractually
(must not be transferable independently of host
derivative) and must have same counterparty
as hybrid*)

*If both conditions are not met, this derivative

is a separate financial instrument and not an
embedded derivative.

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 What is a compound financial instrument?
—SFRS(I) 1-32:28-32, AG30-AG35
A compound financial instrument is a special type of hybrid instrument
where the host contract is a liability of the entity, and the embedded
derivative is an equity instrument of the entity.

Compound financial
instrument
An example of a compound financial
instrument is a convertible bond:

Host Convertible bond

Equity instrument
contract
of entity
Liability
Equity component
component
Bond without Option to convert
conversion bond into issuer’s
option equity

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 Separating host contract from embedded derivative
(a.k.a. Bifurcation or split accounting)
SFRS(I) 9:4.3.2-4.3.7 – When, and when not, to bifurcate a hybrid instrument:

Is host contract a No Are all the following conditions satisfied?:

financial asset? • Embedded derivative qualify as a
derivative under SFRS(I) 9 if independent.
Yes • Economic characteristics and risks of
No embedded derivative not closely related to
those of host contract.
• Hybrid contract not measured at FVTPL.

Yes

Bifurcate. Embedded derivative treated

Do not bifurcate.
separately from host – usually as derivative
Entire hybrid contract
under FVTPL (unless it is an equity component
measured at FVTPL.
of a compound financial instrument).

A holder of a hybrid An issuer of a hybrid instrument

Therefore:
instrument does not bifurcate. must bifurcate.
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 How to bifurcate a compound financial instrument
—SFRS(I) 1-32:28-32, AG30-AG35

n Separation of liability component from equity component is made on

initial recognition and is not subsequently revised, regardless of
changes in likelihood of conversion.
n Initial carrying amount (at fair value or issue price) of compound
financial instrument is allocated to liability and equity components as
follows (a.k.a. incremental method):
w First, determine the carrying amount of liability component as the fair value
(at initial recognition date) of an equivalent liability with same terms and same
credit risk but without conversion option.
w Then, derive the carrying amount of equity component as the difference
between the carrying amount of liability component (above) and carrying
amount of the compound financial instrument as a whole.

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 Accounting for compound financial instrument
(e.g., convertible bond)—SFRS(I) 1-32:28-32, AG30-AG35
On initial recognition • Liability component measured at amortized cost.
— SFRS(I) 1-32:AG31 • Equity component recognized in equity.

On conversion • Liability component derecognized and recognized as equity.

— SFRS(I) 1-32:AG32 • Original equity component remains in equity (but may be
transferred within equity).

On early redemption or • Allocate consideration paid (plus any transaction costs) to

repurchase liability and equity components using the same incremental
— SFRS(I) 1-32:AG33-AG34 method as before.
• Gain or loss on redemption of liability component recognized
in P&L.
• Gain or loss on redemption of equity component remains in
equity.

On change to more favorable Difference between fair value under more favorable conversion
conversion terms terms and fair value under original terms recognized as a loss in
—SFRS(I) 1-32:AG35 P&L.

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 Illustration 3.4: Accounting for convertible bond by issuer
On 31 Dec 20X1, an entity issued the following convertible bond at par:
Terms of convertible bond
Nominal amount $100,000 Value of
convertible
Coupon rate 4.00% bond
Coupon interval Semi-annual
Coupon per period $2,000 Conversion
Issue date 31/12/20X1
Redemption
Coupon payment dates 30Jun & 31Dec
Issue price $100,000
$100K
Transaction costs $3,500
Maturity date 31/12/20X4 Stock
Maturity 3 years price

Conversion At holder’s option $5

Conversion price $5.00 per share Conversion
price
(or Conversion ratio) $100 : 20 shares

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 Illustration 3.4: Accounting for convertible bond by issuer
Had the same bond (with same terms) been issued without any conversion option, and the
prevailing semi-annual effective interest yield is 3% (instead of 2%), the fair value of this
bond at 31/12/20X1 would be $94,583:
%
$2,000 $100,000
( + = $94,583
1 + 3% ! 1 + 3% %
!"#

Using financial calculator: [n = 6, PMT = $2,000, EIR = 3%, FV = $100,000] ⇒ PV = $94,583.

Therefore, allocation of carrying amount of convertible bond between liability and equity
components (net of transaction costs) would be:

Component Allocation of Weight Allocation of Carrying

issue price transaction costs amount
Liability $ 94,583 94.58% $ 3,310 $ 91,273
Equity 5,417 5.42% 190 5,227
100,000 100.00% 3,500 96,500

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 Illustration 3.4: Accounting for convertible bond by issuer

Bond Amortization Schedule of Liability component

(rounded to nearest $):

Date Cash Effective Amortization Unamortized Nominal Gross carrying

interest interest of bond bond amount of amount of
paid expense discount discount bond bond
@ 2% @ 3.6456%*
31/12/20X1 0 0 0 $ (8,727) $ 100,000 $ 91,273
30/06/20X2 $ 2,000 $ 3,327 $ (1,327) (7,400) 100,000 92,600
31/12/20X2 2,000 3,376 (1,376) (6,024) 100,000 93,976
30/06/20X3 2,000 3,426 (1,426) (4,598) 100,000 95,402
31/12/20X3 2,000 3,478 (1,478) (3,120) 100,000 96,880
30/06/20X4 2,000 3,532 (1,532) (1,588) 100,000 98,412
31/12/20X4 2,000 3,588 (1,588) 0 100,000 100,000

*Using financial calculator: [n = 6, PMT = $2,000, PV = –$91,273, FV = $100,000] ⇒ EIR = 3.6456%.

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 Illustration 3.4: Accounting for convertible bond by issuer

31/12/20X1 Dr. Cash: $100,000 – $3,500 $ 96,500

Dr. Bond liability—Unamortized discount 8,727
Cr. Convertible bond liability—nominal $ 100,000
Cr. Capital reserve (equity) 5,227
Issue of convertible bond
30/06/20X2 Dr. Interest expense (P&L) 3,327
Cr. Bond liability—Unamortized discount 1,327
Cr. Cash 2,000
31/12/20X2 Dr. Interest expense (P&L) 3,376
Cr. Bond liability—Unamortized discount 1,376
Cr. Cash 2,000
30/06/20X3 Dr. Interest expense (P&L) 3,426
Cr. Bond liability—Unamortized discount 1,426
Cr. Cash 2,000

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 Illustration 3.4: Accounting for convertible bond by issuer
31/12/20X3 Dr. Interest expense (P&L) $ 3,478
Cr. Bond liability—Unamortized discount $ 1,478
Cr. Cash 2,000
30/06/20X4 Dr. Interest expense (P&L) 3,532
Cr. Bond liability—Unamortized discount 1,532
Cr. Cash 2,000
31/12/20X4 Dr. Interest expense (P&L) 3,588
Cr. Bond liability—Unamortized discount 1,588
Cr. Cash 2,000
Suppose all the bonds were converted into equity on 31/12/20X4.
31/12/20X4 Dr. Convertible bond liability—nominal 100,000
Dr. Capital reserve (equity) 5,227
Cr. Share capital—no par value 105,227
Issue of 20,000 shares on bond conversion.
Within-equity transfer of equity component.

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 Illustration 3.5: Accounting for convertible bond by issuer
– Early redemption through repurchase
Refer Illustration 3.4.

Suppose on 30/06/20X3, the market price of the convertible bond was $103,100, and
the entity decided to redeem the entire bond through a repurchase from the market.
Transaction costs on repurchase and redemption amounted to $3,000.

Suppose the semi-annual effective interest rate for a similar bond without conversion
option on 30/06/20X3 fell to 2.5%.

The fair value of such a bond without conversion option at 30/06/20X3 (after paying
the coupon on that date) would be $98,572:
&
$2,000 $100,000
( !+ = $98,572
1 + 2.5% 1 + 2.5% &
!"#

Using financial calculator: [n = 3, PMT = $2,000, EIR = 2.5%, FV = $100,000] ⇒ PV = $98,572.

Andrew Lee 39
 Illustration 3.5: Accounting for convertible bond by issuer
– Early redemption through repurchase

Therefore, allocation of redemption price (plus transaction costs) at 30/06/20X3—in

accordance with SFRS(I) 1-32:AG33-AG34—would be:

Component Redemption Weight Transaction Redemption Carrying Gain (Loss)

price costs price plus amount on
costs redemption
Liability $ 98,572 95.61% $ 2,868 $ 101,440 $ 95,402 $ (6,038)

Equity 4,528 4.39% 132 4,660 5,227 567

103,100 100.00% 3,000 106,100 100,629 (5,471)

Andrew Lee 40
 Illustration 3.5: Accounting for convertible bond by issuer
– Early redemption through repurchase

30/06/20X3 Dr. Convertible bond liability—nominal $ 100,000

Dr. Loss on redemption of bond (P&L) 6,038
Dr. Capital reserve (equity)* 4,660
Cr. Bond liability—Unamortized discount $ 4,598
Cr. Cash 106,100
Repurchase and redemption of convertible bond
*Credit balance of $567 on equity component remains in capital reserve, and is not to be recognized in P&L.

Andrew Lee 41
 Bonds with detachable equity warrants
n An equity warrant gives the warrant-holder the right to buy a predetermined number of
ordinary shares in the issuing entity at a predetermined price in cash (a.k.a. warrant
exercise price) on or before a predetermined date (warrant expiry date).
n A bond with detachable equity warrant is not a hybrid or compound financial
instrument, because the equity warrant is not embedded in the bond but is a separate
financial instrument (see slide #32-33).
n However, since the warrant is a derivative issued together with the bond, the
accounting treatment of bonds with detachable warrants is similar to convertible
bonds:
Initial Bifurcated in the same manner as convertible bonds:
recognition § Fair value equivalent to a bond with same terms but without the
warrant is recognized as liability.
§ Remaining value is recognized as equity.

Subsequent § Bond component accounted for as a straight bond liability under

measurement amortized cost.
§ Warrant component accounted for separately as equity at cost.

Andrew Lee 42
 Illustration 3.6: Bonds with detachable warrants

On 31 Dec 20X1, an entity Terms of bond with detachable warrants

issued the following bond with Nominal amount of bond $100,000
detachable warrants Coupon rate 4.00%
(all terms are similar to the Coupon interval Semi-annual
convertible bond in Illustration
Coupon per period $2,000
3.4 except for the warrants):
Issue date 31/12/20X1
Coupon payment dates 30Jun & 31Dec
Issue price $100,000
Transaction costs $3,500
Maturity 3 years
Warrants expiration date 31/12/20X4
No. of warrants issued 100,000
Warrant exercise 1 warrant for 1 share at
holder’s option on or
before expiration date
Exercise price $4.50 per share
Andrew Lee 43
 Illustration 3.6: Accounting for bond with warrants by issuer
Had the same bond (with same terms) been issued without any warrants, and the
prevailing semi-annual effective interest yield is 3% (instead of 2%), the fair value of this
bond at 31/12/20X1 would be $94,583:
%
$2,000 $100,000
( + = $94,583
1 + 3% ! 1 + 3% %
!"#

Using financial calculator: [n = 6, PMT = $2,000, EIR = 3%, FV = $100,000] ⇒ PV = $94,583.

Therefore, allocation of carrying amount of convertible bond between liability and equity
components (net of transaction costs) would be:

Component Allocation of Weight Allocation of Carrying

issue price transaction costs amount
Liability $ 94,583 94.58% $ 3,310 $ 91,273
Equity (warrants) 5,417 5.42% 190 5,227
100,000 100.00% 3,500 96,500

Andrew Lee 44
 Illustration 3.6: Accounting for bond with warrants by issuer

Bond Amortization Schedule of Liability component

(rounded to nearest $):

Date Cash Effective Amortization Unamortized Nominal Gross carrying

interest interest of bond bond amount of amount of
paid expense discount discount bond bond
@ 2% @ 3.6456%*
31/12/20X1 0 0 0 $ (8,727) $ 100,000 $ 91,273
30/06/20X2 $ 2,000 $ 3,327 $ (1,327) (7,400) 100,000 92,600
31/12/20X2 2,000 3,376 (1,376) (6,024) 100,000 93,976
30/06/20X3 2,000 3,426 (1,426) (4,598) 100,000 95,402
31/12/20X3 2,000 3,478 (1,478) (3,120) 100,000 96,880
30/06/20X4 2,000 3,532 (1,532) (1,588) 100,000 98,412
31/12/20X4 2,000 3,588 (1,588) 0 100,000 100,000

*Using financial calculator: [n = 6, PMT = $2,000, PV = –$91,273, FV = $100,000] ⇒ EIR = 3.6456%.

Andrew Lee 45
 Illustration 3.6: Accounting for bond with warrants by issuer

31/12/20X1 Dr. Cash: $100,000 – $3,500 $ 96,500

Dr. Bond liability—Unamortized discount 8,727
Cr. Convertible bond liability—nominal $ 100,000
Cr. Warrant reserve (equity) 5,227
Issue of bond with detachable warrants
30/06/20X2 Dr. Interest expense (P&L) 3,327
Cr. Bond liability—Unamortized discount 1,327
Cr. Cash 2,000
31/12/20X2 Dr. Interest expense (P&L) 3,376
Cr. Bond liability—Unamortized discount 1,376
Cr. Cash 2,000
30/06/20X3 Dr. Interest expense (P&L) 3,426
Cr. Bond liability—Unamortized discount 1,426
Cr. Cash 2,000

Andrew Lee 46
 Illustration 3.6: Accounting for bond with warrants by issuer
31/12/20X3 Dr. Interest expense (P&L) $ 3,478
Cr. Bond liability—Unamortized discount $ 1,478
Cr. Cash 2,000
30/06/20X4 Dr. Interest expense (P&L) 3,532
Cr. Bond liability—Unamortized discount 1,532
Cr. Cash 2,000
31/12/20X4 Dr. Interest expense (P&L) 3,588
Cr. Bond liability—Unamortized discount 1,588
Cr. Cash 2,000
Dr. Convertible bond liability—nominal 100,000
Cr. Cash 100,000
Repayment of bond on maturity

Andrew Lee 47
 Illustration 3.6: Accounting for bond with warrants by issuer

Suppose all the warrants were exercised on expiration date:

31/12/20X4 Dr. Cash: 100,000 x $4.50 450,000
Dr. Warrant reserve (equity) 5,227
Cr. Share capital—no par value 455,227
Issue of 100,000 shares on exercise of warrants
Suppose all the warrants expired without being exercised:
No journal entry. Within-equity transfer of warrant reserve permitted but not required.

Andrew Lee 48
 Exchangeable bonds

n An exchangeable bond gives the bondholder the right to convert the bond into
financial instruments (typically equity) of another entity other than the bond issuer, on
or prior to a predetermined date.
n An exchangeable bond is a hybrid but not a compound financial instrument, because
it is not convertible into equity of the issuer but some other financial asset instead
(see slides #33-34).
n Accounting treatment for exchangeable bonds:

Initial Bifurcated in the same manner as convertible bonds:

recognition § Fair value equivalent to a bond with same terms but without the
conversion option is recognized as liability.
§ However, remaining value is recognized as a derivative liability.

Subsequent § Bond component accounted for as a straight bond liability under

measurement amortized cost.
§ Derivative liability of conversion option recognized at FVTPL.

Andrew Lee 49
 Why is A
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Zero coupon exchangeables with such a high exchange premium are rare, Missing
Business Markets
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confidence.
approval, eyes austerity
Oct 18 Singapore's state-owned investment company, Temasek Holdings, has raised S$650 million
Standard Chartered declined to comment on the sale.
($512 million) from the sale of zero coupon bonds exchangeable into Standard Chartered shares.
By Taboola SPONSORED
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Andrew Lee
3 Clinton attacks Trump's outrea
black voters in new ad 50
 Offsetting financial assets with financial liabilities

Andrew Lee 51
 Netting arrangements

In financial markets, two counterparties often enter into netting arrangements with
each other (through legal documentation) to establish for each counterparty a legal
right of set-off to settle or otherwise eliminate all or a portion of an amount due to a
counterparty by applying against that amount an amount due from the same
counterparty.

Netting arrangements are very effective in reducing exposure to counterparty risks,

especially in the event of a default of one party.

With a legal right of set-off between A and B (below), entity A can offset its debt
owing to B against B’s debt owing to A and claim only the net amount of $30 from B.
Similarly, entity B can offset its debt owing to A against A’s debt owing to B and pay
only the net amount of $30 to A.

A owes B $100
Entity A Entity B
B owes A $130

Andrew Lee 52
 Offsetting a financial asset with a financial liability
—SFRS(I) 1-32:42-50, AG38A-AG38F, AG39

n SFRS(I) 1-32:42 – A financial asset and a financial liability shall be

offset, and the net amount presented in the statement of financial
position when, and only when, an entity:
w currently has a legally enforceable right to set off the recognized amounts; and
w intends either to settle on a net basis, or to realize the asset and settle the
liability simultaneously.
n Offsetting is not allowed for financial assets that are subject to any
encumbrances e.g.:
w Assets that are pledged as collateral to other counterparties
w Assets that are held in trust for the purpose of discharging an obligation.
n See also SFRS(I) 1-1:32-35 on offsetting in general.

Andrew Lee 53