Compound financial instruments contain both a liability and equity element from the issuer's perspective. They must be accounted for separately by allocating the consideration received between the liability and equity components. Common examples are bonds with share warrants or convertible bonds. For bonds with share warrants, the allocation is based on the bonds' market value without warrants, with the residual going to the warrants. For convertible bonds, the allocation is based on the bonds' market value without conversion rights.
Compound financial instruments contain both a liability and equity element from the issuer's perspective. They must be accounted for separately by allocating the consideration received between the liability and equity components. Common examples are bonds with share warrants or convertible bonds. For bonds with share warrants, the allocation is based on the bonds' market value without warrants, with the residual going to the warrants. For convertible bonds, the allocation is based on the bonds' market value without conversion rights.
Compound financial instruments contain both a liability and equity element from the issuer's perspective. They must be accounted for separately by allocating the consideration received between the liability and equity components. Common examples are bonds with share warrants or convertible bonds. For bonds with share warrants, the allocation is based on the bonds' market value without warrants, with the residual going to the warrants. For convertible bonds, the allocation is based on the bonds' market value without conversion rights.
Compound financial instruments contain both a liability and equity element from the issuer's perspective. They must be accounted for separately by allocating the consideration received between the liability and equity components. Common examples are bonds with share warrants or convertible bonds. For bonds with share warrants, the allocation is based on the bonds' market value without warrants, with the residual going to the warrants. For convertible bonds, the allocation is based on the bonds' market value without conversion rights.
Definition: - A financial instrument that contains both a liability and an equity element from the perspective of the issuer.
Typical Financial Instrument Asset on one party Liability or Equity on
another party Compound Financial Instrument Asset on one party Liability and Equity on another party
Accounting for Compound Financial Statement
• A compound financial instrument shall be accounted separately - In other words, consideration received from the issuance of such instruments shall be allocated between the liability and equity components using the residual approach.
STEP 1: Compute or determine the fair value of the liability component. (Fair value of the bonds payable i.e. the present value of contractual cash flows) STEP 2: The fair value of the liability component is then deducted from the total consideration received from issuing the compound financial statement. The residual amount is allocated to the equity component.
The residual amount (or the amount left after deducting the fair value of the liability component from the total consideration received) is assigned or allocated to the equity component determined as follows:
Total Consideration xx LESS: Fair Value of the liability component xx Amount allocated to the equity component xx
Common Forms of Compound Financial Instrument
A. Bonds Payable with Share warrants
- When the bonds are sold with share warrants, the bondholders are given the right to acquire shares of the issuing entity at a specified price at some future time. - When bonds are sold with share warrants two securities are sold – the bonds and the share warrants.
Share warrants attached to a bond may be detachable or non-detachable.
• Detachable share warrants can be traded separately from the bond • Non-detachable share warrants cannot be traded separately.
The issue price or total consideration received must be allocated as follows:
Bonds (liability component)- Market value of the bonds ex-warrant (or bonds without the warrants) - If the market value is unknown, the amount to be assigned to the bonds is the present value of future cash payments (principal and interest) using the effective rate for similar bonds without the warrants as of the issuance date. Warrants (equity component)- Residual amount
Journal Entry: Cash xx Disc. On Bonds Payable xx Bonds Payable xx Prem. On Bonds Payable xx Share Warrants Outstanding xx NOTE: Share warrants outstanding is classified as an equity item under SHARE PREMIUM JE upon exercising the share warrants:
Share Warrants Outstanding xx
Share Capital xx Share Premium xx
Example no. 1: On January, 1 20x1, Artemis Company issued 500 of its 5-year, 10% P1000 face value bonds at 112. Each bond includes a warrant that allows the holder to purchase 20 ordinary shares with par value P100 at P110 per share. Interest is payable annually every December 31 of each year.
The market value of the bonds ex-warrant at the time of issuance is 98.
1. What amount shall be assigned to the bonds on the issuance date?
Answer: (500 bonds x P1,000/bond) x 0.98 P500,000 x 0.98 = P490,000 2. What amount shall be assigned to the warrants on the issuance date?
Answer:
Total Consideration (500,000 x 1.12) 560,000
Less: Amount assigned to the bonds (490,000) Amounts assigned to the warrants 70,000
3. Prepare the journal entry to record the issuance of the instrument?
Determined as follows: Face amount of the bonds 500,000 Less: Market Value of the bonds ex-warrant (490,000) Discount on Bonds Payable 10,000
Example no. 2: Exercise of Warrants
Using the example above assume (1) all warrants are exercised (2) 60% of the warrants exercised, the remaining were expired.
Answer no. 1: 1 bond = 1 warrant 1 warrant = 20 ordinary shares @ 110 per share 500 warrants exercised (500 warrants x 20 ordinary shares) = 10,000 ordinary shares @110 per share
JE: Cash (10,000 shares x 110) 1,100,000 Share Warrants Outstanding (70,000 x 100%) 70,000 Ordinary Share Capital (10,000 shares x100) 1,000,0000 Share Premium 170,000
Total cash amount received from exercising the share warrants 1,100,000 Add: Share warrants exercised 70,000 Total 1,170,000 Less: total par value of shares issued (1,000,000) Share premium 170,000
**Or you can just squeeze it
Answer no. 2:
1 bond = 1 warrant 1 warrant = 20 ordinary shares @ 110 per share 300 warrants exercised (500 warrants x 60%) = 6,000 ordinary shares @110 per share
Exercise of Warrants Cash (6,000 shares x 110) 660,000 Share Warrants Outstanding (70,000 x 60%) 42,000 Ordinary Share Capital (6,000 shares x100) 600,000 Share Premium 102,000
Expiration of unexercised share warrants
Share Warrants Outstanding (70,000 x 40%) 28,000
Share Premium 28,000
B. Convertible Bonds - Bonds that can be exchanged into shares or other securities of the issuing entity within a specified period of time.
The issue price or total consideration received must be allocated as follows:
(a) Bonds- Market value of the bonds without conversion privilege - If the market value is unknown, the amount to be assigned to the bonds is the present value of future cash payments (principal and interest) using the effective interest rate for similar bonds without the conversion privilege as of the issuance date. (b) Conversion privilege- Residual amount
JE upon issuance:
Cash xx Disc. On Bonds Payable xx Bonds Payable xx Prem. On Bonds Payable xx Bond conversion privilege outstanding xx
Example no. 1: On January 1, 20x1, Hera company issued 500 of its 5-year, 10% P1000 Face value convertible bonds at 112. Each bond is convertible into 20 ordinary shares with par value of P100 per share. Interest is payable annually every December 31 of each year. The market value of the bonds without the conversion privilege at the time of issuance is 98 1. what is the amount shall be assigned to the bonds without the conversion privilege? Answer: (500 bonds x P1,000/bond) x 0.98 P500,000 x 0.98 = P490,000
2. what amount shall be assigned to the bonds on the issuance date?
Total Consideration (500,000 x 1.12) 560,000 Less: Amount assigned to the bonds (490,000) Amounts assigned to the conversion privilege 70,000
3. Prepare the journal entry to record the issuance of the instrument?
Cash 560,000 Disc. On Bonds Payable 10,000 Bonds Payable 500,000 Conversion privilege outstanding 70,000 Actual Conversion of Bonds
Step 1: Update the carrying amount of the bonds by updating the amortization of the premium or discount to the date of conversion
Step 2: The face amount of the bonds converted shall be cancelled together with the related unamortized discount or premium
Example no. 2: You are provided the ff. selected accounts as of year-end:
12% convertible bonds payable 2,500,000
Premium on bonds payable 100,000 Share capital, P40 par 5,000,000 Share Premium 1,500,000 Bond Conversion privilege outstanding 250,000
Each P1000 face value bond is convertible into 20 ordinary shares. Interest on the bonds is fully paid as of year-end.
Assume that (1) all bonds are converted into ordinary shares (2) 60% of the bonds were converted into ordinary shares
Journal Entry: Bonds Payable 2,500,000 Premium on Bonds Payable 100,000 Bond Conversion privilege outstanding 250,000 Ordinary share capital 2,000,000 Share premium 850,000
Bonds Converted (2,500,000 x 100%) 2,500,000
Add: Related premium on bonds (100,000 x 100%) 100,000 Bond conversion privilege exercised (250,000 x 100%) 250,000 Total 2,850,000 Less: Total par value of shares issued (50,000 shares x 40) (2,000,000) Share Premium 850,000 60% of the bonds were converted into ordinary shares Answer: 1 bond = 20 ordinary shares 1,500 bonds [(2,500,000 / 1000) x 60%] = 30,000 ordinary shares
JE: Bonds Payable 1,500,000 Premium on Bonds Payable 60,000 Bond Conversion privilege outstanding 150,000 Ordinary share capital 1,200,000 Share premium 510,000
Bonds Converted (2,500,000 x 60%) 1,500,000
Add: Related premium on bonds (100,000 x 60%) 60,000 Bond conversion privilege exercised (250,000 x 60%) 150,000 Total 1,710,000 Less: Total par value of shares issued (30,000 shares x 40) (1,200,000) Share Premium 510,000
NOTES: 1. Upon conversion, the entity will issue shares of stock to extinguish the existing liability. Thus, the liability to be extinguished shall be the updated carrying amount of the bonds payable. 2. Bonds payable and Bond conversion privilege are interrelated from one another. When bonds are converted or retired, BCP is extinguished. BCP is presented within share premium. 3. When bonds are retired prior to maturity, the retirement price shall be allocated between bonds and equity component, consistent with how the original issue price was allocated (Residual Approach). The gain or loss on retirement on bonds payable is to be presented within profit or loss while gain on retirement of BCP is presented in share premium and loss on retirement of BCP is charged first to related share premium and any excess is charged to retained earnings. 4. 4. When convertible bond is not converted but paid at maturity, the carrying amount of the bond equal to face value is derecognized, thus, there is no gain or loss on retirement of bonds. The balance of BCP shall be derecognized and credited to share premium. 5. Upon expiration of the bond conversion privilege, the entry is: Bond conversion privilege xx Share Premium xx
