1.Issuers should account for an instrument with both liability and equity charac

Question

1.Issuers should account for an instrument with both liability and equity characteristics entirely as a liability or entirely as an equity instrument depending on which characteristic governs or 2.Issuers should account for an instrument as consisting of a liability component and an equity component that should be accounted for separately. Which of the two options do you favor and why? Develop and explain your argument. In considering this question, you should disregard the current position of the FASB on the issue. Instead, focus on conceptual issues regarding the practicable and theoretically appropriate treatment, unconstrained by GAAP. Also, focus your deliberations on convertible bonds as the instrument with both liability and equity characteristics.

Explanation / Answer

I favour option 2. Reason is that it then represents correct balances for equity and laibility and correct represents the financial information. The same is acceptable as per Accounting standards. IFRS requires that compound instruments should be separated in to their equity and laibility components for purposes of accounting

Initially, the liability component calculation is done as discounting the future cash flows of the bonds @ of similar debt instrument but that is without the option of conversion. Equity component value is the difference between the present value of the liability component and the total proceeds from the issue of bonds. This is known as the residual approach to calculation of equity component that estimates that share option value is equal to the difference between the total proceeds of the convertible bonds and future cash flows present value using the interest rate of a similar debt instrument without the option to conversion.

Also, the interest is chargeable to the income statement based on the effective interest rate, this rate is usually a higher rate, to reflect the true opportunity cost of the financial liability.

Upon maturity of the convertible bonds, the accounting treatment depends on whether the conversion option is exercised or lapsed. If the conversion option is not exercised, the company will have to pay the principal amount of the convertible bonds. Therefore, the outstanding liability may be simply de-recognized. If however, the conversion option is exercised, the company will have to issue shares to the bondholders. Hence, both liability and equity components of the convertible bonds will need to be de-recognized and replaced by share capital reserves as they are treated as consideration for the new shares issue.

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