IAS 32 Compound Instrument - Debit balance in equity

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hishamshams
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IAS 32 Compound Instrument - Debit balance in equity

Post by hishamshams »

Dear fellow members,

This query/forum thread is in relation to a technical query regarding the treatment of compound financial instruments as per IAS 32. Per the standard, the residual value measured i.e. the difference between the fair value of the compound instrument (computed using the market rate) and the net present value of the future cash flows (computed using the coupon rate or interest rate agreed) should be accounted for as an equity component. Most of the technical guidance provides illustration wherein the market rate is higher than the coupon rate for a convertible note with no conversion option. However, the standard is not clear regarding the treatment if ever the coupon rate is significantly higher than the market rate, in which case the residual value would have a debit balance. My query is, considering that the coupon rate is significantly higher than the market rate, would the debit balance (residual amount) be recognized under equity as a debit balance? or would it be recognized under profit or loss as a discounting impact expense or premium expense?

Appreciate your response and support.
Last edited by hishamshams on 03 Mar 2021, 19:17, edited 1 time in total.
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Marek Muc
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Re: IAS 32 Compound Instrument - Debit balance in equity

Post by Marek Muc »

is this a real-life example? what is the economic reason for such anomaly?
hishamshams
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Re: IAS 32 Compound Instrument - Debit balance in equity

Post by hishamshams »

Hi Marek, this is a technical query we've received from one of our clients. Currently they have issued bonds at a coupon rate lower than the market rate for a similar instrument with no conversion option. So there's no issue with the accounting. However, the client is curious to know how should the convertible note be accounted for should the coupon rate be significantly higher than the market rate. The rationale could be to attract quick funding considering the market conditions. Please let me know your thoughts.
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Marek Muc
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Re: IAS 32 Compound Instrument - Debit balance in equity

Post by Marek Muc »

I see, if the reason is that it would not be possible to issue such an instrument without the conversion option, then we cannot say that there is a potential for debit entry to equity. I mean, if entity offers yield at, say, 5% + conversion option, then we cannot say that the yield would be lower without the conversion option, I don't see any logic in it.
hishamshams
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Re: IAS 32 Compound Instrument - Debit balance in equity

Post by hishamshams »

Yes, this is not a transaction that'd happen in an ideal scenario. But assuming that the entity issues convertible bond with a conversion option at a higher coupon rate than the market rate, again the possibility of such an issuance of bond with a huge premium is remote I feel, how would the debit balance be treated?

Tried searching for this particular scenario in various resources, but unfortunately couldn't find any.
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Marek Muc
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Re: IAS 32 Compound Instrument - Debit balance in equity

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This discussion becomes recursive :) I then ask what is the economic reason that makes a company pay a higher yield for convertible bond when compared to regular bond with identical terms except for the conversion option?
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exIFRS
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Re: IAS 32 Compound Instrument - Debit balance in equity

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Surely you can't have a negative equity component, as this would imply that an equity holder is expecting to have to pay more to the firm, but that would be a liability not equity. This is why you never see a share with a negative value. One of the things about being an equity holder is that only your invested capital is a risk.

From what I understand of what you are saying, when the coupon rate is higher than the market rate you either end up selling the debt at a premium, raising more cash. Effectively equating the principal raised to the market interest rate once the coupon rate is factored in. On the other hand if the principal raised is the face value equivalent to the coupon rate then it is reimbursing debt holders for higher perceived risk, so in fact is the correct "market" rate for the level of risk.
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Marek Muc
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Re: IAS 32 Compound Instrument - Debit balance in equity

Post by Marek Muc »

Maybe there's a misunderstanding on your client's side on what "market rate" should mean in this scenario. This "market rate" is really a rate for identical liability but without the equity conversion option, not just some benchmark rate for other issuers.
DJP
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Re: IAS 32 Compound Instrument - Debit balance in equity

Post by DJP »

Correct. The market rate should be adjusted for the issuer's credit risk. For this transaction to make sense, that credit risk must be quite high.
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Re: IAS 32 Compound Instrument - Debit balance in equity

Post by JRSB »

I came across this once and the outcome was that the equity component was ignored
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Re: IAS 32 Compound Instrument - Debit balance in equity

Post by JRSB »

I saw this was published the other day. (Don't know if it has the answer...)!

https://global-www.bdo.global/getmedia/ ... s.pdf.aspx
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