Irredeemable bond in foreign currency

[Leo]

A irredeemable bond in usd that is convertible into a fixed numbers of shares in use at the option of the holder, issued by an entity with a functional currency in euros.

Would it be classified as liability or equity?

[Ketan Marwah]

Hi,

Is the amount fixed in USD, Euros or neither of two?
Is the bond interest bearing?

[Leo]

No interest.

[Ketan Marwah]

How about characteristics of amount when converted?

[Leo]

In usd, shares will be issued in usd

[Ketan Marwah]

So isn’t this the same discussion then as we had the other day. It could be presented as:
1) Either equity (Non-interest bearing perpetual debt) + liability (conversion feature derivative) OR
2) Liability as the entity is not obliged to deliver a fixed number of its own equity instruments for fixed consideration. Even if there would have been a fixed amount denominated in USD then the test would have failed still as the fixed amount must be expressed in the functional currency of the entity I.e. Euro (IAS 32.21)

Don’t you think the same?

[Leo]

Thanks for taking time to discuss.

My point is whether we treat this as a non-derivative, then, it seems that the wording seems to suggest only the obligation to deliver fixed number of shares, without the other leg being fixed cash.
If the bond is to deliver a fixed number of shares in the functional currency of the company, then it's an equity, because it's can be seen as you have already bought the shares. I can't see why would the fact that the shares are in a foreign currency would change the classification. Because an entity can issue shares in euros, and USD, it's not because they issue shares in USD that the shares are liability?

Or treat this as a derivative, then, fixed for fixed, i.e., fixed cash for fixed number of shares. Since USD is not the functional currency of the entity, then, it's a liability. because it is variable cash for a fixed number of shares.


"a contract that will or may be settled in the entity's own equity instruments and is:
1. a non-derivative for which the entity is or may be obliged to receive a variable number of the entity's own equity instruments
2. a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments."

[Ketan Marwah]

Hey Leo,

No worries. Any amount of IFRS sparring is always welcome and appreciated. A request though that please don’t paste full para’s in your replies as that makes the post lengthy. You can trust on my ability to access IFRS para’s basis what you quote . Let’s discuss it further now:

1) Currency other than the entity’s functional currency is considered to be a variable that is independent of the entity’s available economic resources, and therefore, a derivative on own equity that includes a foreign currency variable would be classified as a financial asset or a financial liability.
2) I would view it as a derivative as the conversion features that fail 'equity' classification are derivatives.

[Leo]

But the initial investment is immaterial, is it a derivative?

[Ketan Marwah]

Hi,

Let me elaborate:

The preferred approach to classification is that when classifying a financial instrument, an entity would firstly identify an obligation that has a feature of a non-derivative financial liability. The obligation to pay a fixed amount at liquidation (perpetual debt) would be classified as a non- derivative financial liability because of the ‘independent amount’ even if it is only payable at liquidation.

If the financial instrument contains alternative settlement outcomes, the entity would apply the derivative classification principle to those contractual rights and obligations, in this case the conversion obligation. Applying this principle would result in a derivative financial liability classification because the conversion feature in this case represents an obligation to exchange a fixed number of own shares for extinguishing a financial liability that is denominated in a foreign currency—a derivative on own equity that includes an ‘independent variable’, being foreign currency.

This therefore makes a derivative sit atop a non derivative financial liability.
Signing off for today to enjoy the remaining weekend but happy to carry along tomorrow in case there is a contrarian view. Others are obviously quite welcome to chime in:-).

[Leo]

1. A principal only payable on liquidation is not a liability. A perpetual debt, is a debt not because it's payable on liquidation, it's because the interest, if it is payable, will "eat up" the principal so that there is no amount left to be recognised in equity.

2. In the case that the holder exercises the conversion option, the entity the obligated to deliver a fixed number of shares. Not sure there is a "option".

I can see what you meant, often, a bond is convertible into shares, otherwise would be paid in cash. But here, the bond is only convertible into shares, otherwise, would never be redeemed.

Have a good weekend

[Ketan Marwah]

Hi,

I did not attribute the liability nature owing to the perpetual nature of the instrument. I clarified that point upfront in the discussion with the question about interest bearing nature of the instrument. I attributed the liability nature due to an unavoidable contractual obligation for an amount independent of the entity’s available economic resources and most likely at liquidation, the instrument ranks just above ordinary shares but below all other claims therefore it do not really evidence a residual interest in the assets of an entity after deducting all liabilities to be classified as equity.
Having said the above, I would agree that the above suggested classification could represent a fundamental departure from the classification approach in IAS 32 because applying paragraph 25(b) of IAS 32, obligation that arises only on liquidation of the entity does not result in a financial instrument with a contingent settlement feature being a financial liability. The two options that appears therefore are:

1) If I apply IAS 32 strictly then it could be classified as equity host with a derivative on own equity that includes a foreign currency variable.

2) Classified as equity in its entirety because they are viewed as a non-derivative financial instrument with an obligation to deliver a fixed number of own shares.

What do you think?

[Leo]

Again, it seems there are different views on this. I partially share your conclusion. But I also see another conclusion which is entirely liability because it's not fixed for fixed.

Thanks Ketan. Again, if someone in this forum like to contribute some thoughts, that'd be welcoming.