237 / 488
228
Case Study 3
Wiley IFRS: Practical Implementation Guide and Workbook
This case illustrates the accounting fo r issued convertible debt instruments.
Facts
On October 31, 20X5, Entity A issues convertible bonds with a maturity of five years. The issue is for a
total of 1,000 convertible bonds. Each bond has a par value of $ 100,000, a stated interest rate is 5% per
yea r, and is conve rtible into 5,000 ordinary shares of Entity A. The convertible bonds are issued at par.
The per-share price for an Entity A share is $ 15. Quotes for similar bonds issued by Entity A without a
conversion option (i.e., bonds with similar principal and interest cash flows) sugges t that they can be
sold for $90,000.
Required
(a) Indicate how Entity A should account for the compound instrument on initial recognition.
(b) Determine whether the effecti ve interest rate will be higher, lower, or equal to 5%.
So lution
Entity A should separate the liability and equity components of the convertible bonds using the with–
and-without method. First, it should determine the fair value of the liability element. Thi s is equal to
$90,000 because similar bonds without an equity component sell for $90,000. According ly, the initial
carry ing amount of the liability component is $90,000. Second , it should determine the initial carry ing
amount of the equity component. This is equal to the difference betwe en the total proceeds received
from the bond of $ 100,000 and the initially allocated amount to the liability component of $90,000.
Therefore, the carrying amount of the equity component is $ 10,000. The journal entry is
Dr Cash
100,000
Cr Financial liability
90,000
Cr Equity
10,000
Th e effective interest rate is higher than 5% because it includes amortization of the difference between
the initial carrying amount of the liability component of $90,000 and the principal amount of the liability
of $ 100,000. (The effective interest rate is 7.47%.)
3.3 Instruments That Will
or
May Be Settled in Own Equity
3.3.1
Sometimes entities enter into contracts that will or may be settled in equity instruments is–
sued by the enti ty ("own equity").
Example
A
contract may specify that the entity is required
to
deliver as many of the entity 's own equity in–
struments as are equal in value to $100,000 on
a
future date. ln that case, the number of shares that
will be delivered will vary based on changes in the share price.
if
the share price increases, few er
shares will be delivered.
if
the share price decreases, more shares will be delivered.
Alternatively, a contract may specify that the entity is required to deliver as many ofthe entity's own
equity instruments as are equal in value
to
the value of l Oa ounces of gold on a f uture date. In that
case, the number of shares that will be delivered will vary based on changes in both the share price
and the gold price.
if
the share price increases, f ewer shares will be delivered. lf the share price de–
creases, more shares will be delivered. lf the gold price increases, more shares will be delivered.
if
the gold price decreases. f ewer shares will be delivered.
3.3.2
Contracts that will
or
may be settled in the entity' s own equity instrume nts are classified as
equity instruments of the entity if they
• Are nonderivative contracts and will be settled by issuance of a fixed number of the entity's
own equity instruments;
or
• Are derivative contracts and will be settled by the exchange of a fixed number of the entity' s
own equity instruments and a fixed amount of cash.
3.3.3
Because such instruments are classified as own equity, any considera tion received for such
an instrument is added directly to equ ity and any consideration paid is deducted directly from eq–
uity. Changes in fair value of such instruments are not recognized .
Example
Examples of instruments that will or may be settled in own equity and are classified as equity in–
struments ofthe entity are