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IAS 32 and 39, IFRS 7 and 9 - Liability and equity hybrids

Executive summary

Both IFRS and US GAAP have definitions for financial instruments that are classified as a
liability or as equity. Under IFRS, classification of certain instruments with characteristics of
both debt and equity focuses on the contractual obligation to deliver cash, assets or an entitys
own shares. US GAAP specifically identifies certain instruments with characteristics of both
debt and equity that must be classified as liabilities.

Under IFRS, hybrid financial instruments (e.g., convertible bonds) are required to be split into
a debt and equity component and, if applicable, a derivative component. The derivative
component may be subject to fair value accounting. Under US GAAP, hybrid financial
instruments are not split into debt and equity components unless certain specific conditions
are met, but they may be bifurcated into debt and derivative components, with the derivative
components subject to fair value accounting.

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Progress on convergence

The Boards agreed to review the accounting for financial


instruments with characteristics of equity. The FASB issued its
Preliminary Views document in November 2007, and the IASB
issued a Discussion Paper in February, 2008. Both documents
were titled Financial Instruments with Characteristics of Equity.
The objective of the joint project and related discussion
documents was to improve and simplify the financial reporting
requirements in this area. The Boards received comments on
their respective documents, deliberated various issues of the
project and made a number of decisions on financial instruments
with characteristics of equity. However, with all of the other
convergence projects, the Boards decided in October 2010, that
they did not have the capacity to devote to the project and
decided to not issue an ED until sometime after June 2011.

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Definitions

US GAAP

IFRS

Standards define the following:


Financial instruments
Financial liabilities
Equity instruments

Similar

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Definitions

US GAAP

IFRS

The definitions are central to the analysis


of how to account for financial
instruments:

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A financial instrument is any contract that


gives rise to a financial asset of one entity
and a financial liability or equity instrument
of another .

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Definitions

US GAAP

IFRS

A financial instrument, per ASC 825-10-20-Glossary, is defined as cash,


evidence of an ownership interest in an entity, or a contract that both:

a. Imposes on one entity a contractual obligation either:


1. To deliver cash or another financial instrument to a second entity.
2. To exchange other financial instruments on potentially unfavorable
terms with the second entity.
b. Conveys to one entity a right to do either of the following:

A financial instrument,
per IAS 32, paragraph
11, is any contract
that gives rise to a
financial asset of one
entity and a financial
liability or equity
instrument of another

1. Receive cash or another financial instrument from the first entity.


2. Exchange other financial instruments on potentially favorable terms
with the first entity.
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Definitions

US GAAP

A financial liability, per ASC


825-10-20-Glossary is defined
as a contract that imposes on
one entity an obligation to do
either of the following:

a. Deliver cash or another


financial instrument to a
second entity, or
b. Exchange other financial
instruments on potentially
unfavorable terms with the
second entity.

IFRS

A financial liability, per IAS 32, paragraph 11, is any liability that
is:

(a) A contractual obligation


(i) To deliver cash or another financial asset to another entity, or
(ii) To exchange financial assets or financial liabilities with another entity
under conditions that are potentially unfavourable to the entity; or
(b) A contract that will or may be settled in the entitys own equity
instruments and is
(i) a non-derivative for which the entity is or may be obliged to deliver a
variable number of the entitys own instruments .
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Definitions

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Definitions

US GAAP

IFRS

An equity instrument is not as yet well defined under US GAAP.

By reference to ASC 320-10-20, Investments-Debt and


Equity Securities-Glossary, an equity security is any security
representing an ownership interest in an entity (e.g.,
common, preferred or other capital stock) or the right to
acquire (e.g., warrants, rights and call options) or dispose of
(e.g., put options) an ownership interest in an entity at fixed
or determinable prices.

Under ASC 505-10-05-3, Equity-Overall-Overview and


Background, equity is defined as the residual interest in the
assets of an entity that remain after deducting its liabilities.
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An equity instrument,
according to IAS 32,
paragraph 11, is any
contract that
evidences a residual
interest in the assets
of an entity after
deducting all of its
liabilities. This
includes common
shares and certain
preferred shares.
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Definitions

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Classification, recognition and measurement

US GAAP

IFRS

Financial instruments must be classified as


debt or equity in the balance sheet.

Similar

Liability and equity hybrid financial instruments


can be very complex and require a great deal of
judgment to evaluate all characteristics of the
underlying instrument.

Similar

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Classification, recognition and measurement

US GAAP

IFRS

Instruments that require settlement with a


variable number of shares establish a
debtor/creditor relationship and are thus treated
as liabilities. This is true even if the legal form
is preferred stock. Those that require
settlement with a fixed number of shares
generally establish more of a shareholder
relationship and are thus treated as equity.

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Similar, although preferred stock


is referred to as preference
shares.

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Classification, recognition and measurement


Classification of debt versus equity

IFRS

Classification starts with the


definitions.

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The focus is on whether there is a


contractual obligation to deliver cash,
other assets or a variable number of the
entitys own shares. If such an
obligation exists, a liability exists. This
is applied to all instruments whether
they are loans/bonds or preferred or
common stock. Unless the entity has an
unconditional right to avoid delivering
cash or other financial assets, it is a
liability. IAS 32, paragraphs 17
through19 address this issue.
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Bifurcation of hybrid financial instruments

US GAAP

Hybrid financial instruments are not


split into debt and equity
components unless certain
conditions are met, as may be the
case with instruments that include
embedded derivatives, conversion
features, redemption features, etc.
Careful analysis is required on an
individual instrument-by-instrument
basis to determine if bifurcation is
appropriate.

Related debt issuance costs are


recorded as deferred assets and
amortized over the life of the liability.

IFRS

The liability and equity components are determined as follows:

The liability component is calculated as the net present


value of all potential contractual future cash flows at market
interest rates at the time of issuance.

The difference between the proceeds from the offering and


the net present value calculated above is the equity
component. This component is included in equity generally
under a heading of other capital reserves.

Issuance costs are also bifurcated by determining the fair value


of the components and applying the percentage to the issuance
costs. Liability component issuance costs are offset directly to
the balance of the liability component. Equity component
issuance costs are charged to equity generally under a heading
of other capital reserves.

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Debt versus equity hybrid instruments example


Example 1
Hang Glide Inc. (Hang) issues $2.0 million worth of convertible bonds at par with an annual
interest rate of 6% when the market rate is 9%. The bonds, due in three years, are convertible
into 250 common shares.

Prepare the initial journal entry to record these


bonds under US GAAP and IFRS.

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Debt versus equity hybrid instruments example


Example 1 solution:
US GAAP:
Cash
$2,000,000
Bonds payable
Split accounting would not apply.

$2,000,000

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Debt versus equity hybrid instruments example


Example 1 solution (continued):
IFRS: The instrument would be split into a debt component (measured at the present value of the
cash flows of the debt at the market rate of interest) with the equity components being the residual.
The present value at three years, 9% annual interest of $120,000 and principal repayment of
$2,000,000:
Interest $120,000 (PV annuity)
Principal $2,000,000 (par value $1)
Value of liability
$1,848,122
Value of equity = $2,000,000 $1,848,122 = $151,878
Cash
$2,000,000
Bonds payable $1,848,122
Equity conversion option

151,878
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$ 303,721
1,544,401

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Convertible debt example


Example 2:
The Really Cheap Company (RCC) issued $20 million of five-year convertible bonds at par with 6% annual interest,
which would be due December 31, 2015. The 6% bonds are convertible at any time after issuance, which was
January 1, 2011, at the rate of 10 shares of common stock for each $1,000 of the face value of the convertible
bonds. Issuance costs total $100,000. The current market rate for non-convertible bonds is 8% interest.

Show the journal entries to record the issuance of the


convertible bonds using US GAAP and IFRS (round to the
nearest thousand).

Calculate the expenses related to the convertible debt that


RCC should record each year using US GAAP and IFRS
(round to the nearest thousand). Provide the journal entries.

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Convertible debt example


Example 2 solution:
Issuance of convertible bonds:
US GAAP:
RCC would record a liability for the amount of the bonds and a deferred charge for the issuance
costs.
Cash
Unamortized bond issuance costs
Convertible bonds payable

$19,900,000
100,000
$20,000,000

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Convertible debt example


Example 2 solution (continued):
IFRS:

Cash flow

NPV at 8%

Year 1

$ 1,200,000

$ 1,111,000

RCC should calculate the liability component as the net


present value (NPV) of future cash flows using the current 8%
market rates at the time of issuance.

Year 2

$ 1,200,000

1,029,000

Year 3

$ 1,200,000

953,000

Cash flow for year 1 through year 4 is the interest payment


calculated as $20,000,000 x 6% = $1,200,000.

Year 4

$ 1,200,000

882,000

Year 5

$21,200,000

14,428,000

RCC needs to bifurcate the convertible debt and issuance


costs between liability and equity components.

Cash flow for year 5 includes the proceeds of $20 million and
interest of $1.2 million.
Based on the NPV of these cash flows, the liability component
is calculated as $18,403,000 as shown in the table.

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Fair value
of liability
component

$18,403,000

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Convertible debt example


Example 2 solution (continued):
RCC then calculates the equity component
of $1.597 million as the proceeds of
$20 million less the liability component of
$18.403 million.
The issuance costs would be allocated to
equity based on the equity component
percentage as follows:
$1,597,000/$20,000,000 = 8%
The equity component issuance costs are
$8,000 (8% x $100,000).

The journal entry would be as follows:


Cash
$19,900,000
Convertible bonds payable
$18,311,000
Other capital reserves
1,589,000
Cash received would be $20 million less $100,000 of
issuance costs.
The convertible bonds would be recorded as
$18.403 million with an offset for debt issuance costs of
$92,000.
Other capital reserves in equity would be credited with
$1.597 million and charged with issuance costs of $8,000.
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Convertible debt example


Example 2 solution (continued):
US GAAP:
RCC should record amortization of bond issuance expense annually of $20,000, calculated as the total of
the issuance costs of $100,000 amortized on a straight-line basis over the five-year life of the bonds.
RCC should record interest expense of $1.2 million each year, calculated as $20 million multiplied by the
stated rate of 6%.
The journal entries for each year would be as follows:
Amortization expense
$20,000
Unamortized bond issuance costs
Interest expense
$1,200,000
Cash

$20,000
$1,200,000

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Convertible debt example


Example 2 solution (continued):
IFRS: In substance, the amount of interest expense should reflect the
effective interest assuming the bonds did not have the convertible feature.
Therefore, the effective interest rate on this debt is determined by solving
for the effective yield on the difference between the face value of the
bonds of $20.0 million and the amount allocated to the liability component
of $18,311,000. The effective interest rate is 8.125%. Therefore, interest
expense by year would be as follows:
Beginning
liability
Year 1

$18,311,000

Year 2

$18,599,000

Year 3

$18,910,000

Year 4

$19,246,000

Year 5

$19,609,000

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Interest
expense
at 8.125%
$
1,488,000
1,511,000
1,536,000
1,563,000

Interest paid

Ending
liability

$(1,200,000)

$18,599,000

(1,200,000)

$18,910,000

(1,200,000)

$19,246,000

(1,200,000)

$19,609,000

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1,591,000

(1,200,000)

$20,000,000

Journal entries:
Year 1:
Interest expense
Cash
Liability
Year 2:
Interest expense
Cash
Liability
Year 3:
Interest expense
Cash
Liability
Year 4:
Interest expense
Cash
Liability
Year 5:
Interest expense
Cash
Liability

$1,488,000
$1,200,000
288,000
$1,511,000
$1,200,000
311,000
$1,536,000
$1,200,000
336,000
$1,563,000
$1,200,000
363,000
$1,591,000
$1,200,000
391,000
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Classification, recognition and measurement

Stock or shares with settlement options that are contingent upon another event

US GAAP

IFRS

These financial instruments are not


classified as liabilities until the instruments
are mandatorily redeemable.

For example, a share may become


redeemable if a certain future event
happens (such as a consumer price index
rising above a certain point). This future
event is uncertain. When the contingency
resolves itself in the future (i.e., occurs or
not), the instrument is reassessed to see if
a liability exists. If it does, an amount
equaling the fair value of the liability is
reclassified from equity to liability.

These instruments are recognized as


liabilities if the issuer does not have an
unconditional right to avoid delivering cash
or another financial asset.

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Per IAS 32.25, there are certain limited


situations when such instruments would not
be classified as liabilities.

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Debt versus equity contingency example


Example 3
On December 31, 2011, the Motor Cross Company (MCC) issued redeemable preferred shares for
$100 that are redeemable if the S&P index rises beyond a certain benchmark. On December 31,
2013, the S&P reaches the benchmark.

How should MCC account for these shares


under US GAAP and IFRS at
December 31, 2011 and December 31, 2013?

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Debt versus equity contingency example


Example 3 solution:
US GAAP:
Upon issuance, the shares are only contingently redeemable (as opposed to mandatorily redeemable). US
GAAP does not use split accounting for these, and the legal form is equity. Therefore, the shares are initially
treated as equity. However, on December 31, 2012, a liability is created and now the shares are indeed
mandatorily redeemable. An amount equal to the fair value of the liability would be reclassified from equity and
to a liability classification on the balance sheet.
2010
Cash
$100
Redeemable preferred shares equity
2012
Redeemable preferred shares equity
Redeemable preferred shares liability

$100

$100
$100
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Debt versus equity contingency example


Example 3 solution (continued):
IFRS:
At December 31, 2010, a liability exists. MCC has an obligation to repay the principal if a future
event occurs that is beyond its control. Since MCC does not have an unconditional right to avoid
delivering the cash, the instrument is a liability.
2010
Cash
Redeemable preferred shares liability

$100
$100

2012
There are no journal entries necessary.
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Classification, recognition and measurement


Preferred stock

US GAAP

IFRS

Preferred shares that pay dividends do not


require bifurcation.

Preference shares that pay dividends may


require bifurcation. The present value of
the dividend payments will be classified as
a liability, even if the preferred shares are
otherwise classified as equity.

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Preferred stock example


Example 4
The Rock Star Records Company (RSR) decides to issue $20 million of
redeemable preferred stock (preference shares using IFRS terminology) on
January 1, 2011. The redeemable preferred stock has a 5% fixed annual
cash dividend (no vote of shareholders or others is required), has no maturity
date and RSR can repay it at any time. Current market interest rates are 5%.

Explain how RSR should account for the preferred stock using US
GAAP and IFRS. (No journal entries required.)

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Preferred stock example


Example 4 solution:
For US GAAP, which does not require split accounting, these shares would be evaluated for their redemption
features. If there were any redemption features required upon the occurrence of certain contingent events
(e.g., an IPO, change in control, liquidation event, achievement of a performance condition) or upon the option
of the holder, then this instrument would be classified as a liability. However, if redemption of the instrument is
not certain to occur, which is assumed in this example, the instrument is classified as equity for US GAAP
purposes.
For IFRS purposes, split accounting would be considered and the components of the instrument would be
evaluated for liability and equity characteristics:

The repayment of the principal would be considered an equity instrument as payment is at the issuers
option and there is no present obligation to transfer financial assets to the holder.

The dividend is fixed and payment is not at the discretion of the issuer, thus this represents a mandatory or
potential obligation to transfer assets or cash to the holder. Accordingly, the dividend component of the
financial instrument would be a liability.
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Preferred stock example


Example 4 solution (continued):

The fair value of the stream of perpetual dividends would be substantially equivalent to the
face value of the preferred stock. Therefore, little to no value will actually be ascribed to the
residual equity component, and the preferred stock issuance would be classified as a liability.

Also, if the principal amount is paid at some point after issuance, then this would be an
indication that the issuance was debt and was classified appropriately as a liability.

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