Compound Financials Instruments

Understanding Compound Financial Instruments

In the world of finance, compound financial instruments are sophisticated tools that combine multiple financial assets or liabilities into a single package. These instruments offer unique opportunities and challenges for investors and issuers alike.

A. Definition

Compound Financial Instruments are financial instruments that contain both a liability and an equity component from the issuer's perspective. Under Indian Accounting Standards (Ind AS), particularly Ind AS 32 and Ind AS 109, Compound Financial Instruments are accounted for by separating the components into their respective elements.

B. Items of Compound Financial Instrument and its Presentation in Financial Statements

Presentation in Financial Statements

According to Ind AS 32, the financial instrument is split into a liability and an equity component at initial recognition. The liability component is measured at the fair value of a similar liability without an equity conversion option, and the equity component is measured as the residual amount.

Examples

? Convertible bonds: Bonds that can be converted into a predetermined number of the issuer's equity shares.

? Convertible preference shares: Preference shares that carry the option to be converted into ordinary shares.

? Callable and puttable financial instruments: Instruments that include options for the issuer to call or for the holder to put the instrument back to the issuer.

C. Accounting

1. Measurement

Compound Financial Instruments are measured at fair value initially. Subsequent measurement depends on whether they are classified as financial liabilities or equity instruments. Financial liabilities are measured at amortized cost or fair value through profit or loss, while equity instruments are not remeasured.

2. Option with Holder and Issuer

Options embedded in Compound Financial Instruments can be classified as equity or liability based on specific criteria.

Holder: Options embedded in Compound Financial Instruments can be classified as equity or liability based on specific criteria. For instance, if the issuer has an obligation to deliver cash or another financial asset, the instrument is classified as a liability.

Issuer: The issuer's perspective involves assessing whether the number of equity instruments to be issued and the amount of cash or financial assets to be paid are fixed. If this condition is met, the instrument is classified as equity. If not, it is classified as a liability.

3. Fixed-to-Fixed Test

The fixed-to-fixed test assesses whether the number of equity instruments to be issued and the amount of cash or financial assets to be paid are fixed. If this condition is met, the instrument is classified as equity. If not, it is classified as a liability.

4. Discussion Regarding Diluted EPS

Diluted Earnings Per Share (EPS) considers the potential dilution that could occur if securities or other contracts to issue ordinary shares were exercised or converted. Compound Financial Instruments impacting EPS calculations include convertible bonds and share options. The "if-converted" method is typically used for convertible securities.

5. Discussion Regarding Deferred Tax

Deferred tax implications arise from the temporary differences between the carrying amounts of Compound Financial Instruments in the financial statements and their tax bases. The equity component of Compound Financial Instruments does not create a deductible temporary difference, whereas the liability component may lead to a deferred tax liability.

D. Disclosure Requirements with Example

Ind AS 32 requires detailed disclosures to ensure transparency regarding Compound Financial Instruments. The required disclosures include:

? The terms and conditions of the financial instruments.

? The accounting policies applied, including the method of separating the components.

? Information on the fair value of each component at initial recognition.

? The impact of Compound Financial Instruments on the entity's financial position and performance.

Example Disclosure

In the notes to the financial statements:

"The company issued convertible bonds on January 1, 2024, with a principal amount of Rs. 10 million, maturing on January 1, 2029. The bonds are convertible into ordinary shares of the company at the option of the holder at a conversion rate of 100 shares per Rs. 1,000 principal amount. At initial recognition, the liability component was measured at Rs. 8 million, and the equity component was recognized as Rs. 2 million, representing the residual amount. The liability component is measured at amortized cost using the effective interest rate method, and the equity component is not remeasured. The bonds have an effective interest rate of 5%."