Working out the correct effective interest rate for convertible notes is not straightforward!

In a previous article, we reminded our readers that the very narrow definition of equity in IFRS means that convertible notes are rarely accounted for as equity instruments in their entirety. Convertible notes and other similar forms of financing typically have various combinations of debt, derivative and equity features. The accounting is often complicated and not well understood.

Convertible notes and other similar financing arrangements continue to be attractive source of funding, as they typically involve minimising cash outflows in servicing the debt, and in many cases allow the entity to secure funds that they would not otherwise be able to. ??It is very popular amongst startup companies across a variety of industries including exploration, mining, technology, health sciences, financial services, biotechnology, media etc.

For investors, convertible notes usually allow them the rights to participate in the upside returns of the company or project, while being offered a minimum return for their investment by way of a coupon interest.

When accounting for convertible notes under IFRS, many convertible note or similar types of arrangements may contain three components, being:

• A host debt instrument – being a financial liability
• Derivative liabilities (usually the conversion feature); and
• Equity instruments (including attaching options/free warrants).

In many instances, when accounting for convertible notes, issuers and their auditors are able to identify the financial liability component within a convertible note.

However, determining the correct effective interest rate under IFRS 9 often proves to be challenging. How the effective interest rate is determined under IFRS 9 is often not well understood. Many issuers incorrectly adopt the coupon rate as the effective interest rate.

Coupon rate vs effective interest rate

Many convertible note agreements specify an interest rate that is payable on a regular basis e.g. quarterly, semi-annually, annually, or in some cases it is capitalised into final repayment amount at the end of the note, this rate is the “coupon rate”.? The coupon rate determines the cash out flow required during the life of the note, or if capitalised, the final principal repayment amount.

On the other hand, the effective interest rate reflects the “true return” that an investor would require, or the “true cost” of the funding arrangement to the issuer and is typically higher than the coupon rate. This is because the effective interest rate reflects not just the “coupon rate”, that effectively guarantees a minimum return for the investor, but also the value of the options and embedded derivatives granted to the investor, that enable them to participate in any potential upside of the entity/ project.

Impact of an incorrect effective interest rate

Not determining the effective interest rate correctly can impact the issuer’s:

• Reported finance costs
• Reported profit or loss for the period
• Interest coverage ratio.

Not recognising the interest expense at the correct effective interest rate can result in the following accounting consequences:

• The host debt liability not accreting back to the final repayment amount at the end of the life of the note.
• The incorrect amount being recognised in equity when the note converts into shares.

Determining the effective interest rate

The effective interest rate is determined differently, depending on whether the convertible note is:

• A compound financial instrument, containing liability and equity components; or
• A ‘hybrid financial instrument ’containing a host debt liability and derivative liabilities.

Compound convertible note

For a compound convertible note, i.e.? a note with a liability and equity component. The effective interest rate is the rate that would apply to an identical financial instrument, with the same terms, but without the conversion options or other attaching 'free' warrants etc. The effective interest rate is typically higher than the coupon rate stated in the convertible note agreement, as the effective interest rate reflects the market rate of return that the investors would require. The coupon rate is a ‘discounted rate’ that the investor is willing to accept in return for the right to participate in the potential upside of the company.

Hybrid convertible note

When a convertible note contains a derivative liability and a liability component, the fair value of derivative liability is determined first on initial recognition. The initial carrying amount of the liability is the residual amount after deducting the fair value of the derivative from the transaction price. The effective interest rate is the rate that exactly discount the future cash payments of the note to the initial carrying amount of the liability. This again, results in an effective interest being higher, and some case significantly higher, than the “coupon rate”.

Modifications and extensions

It is quite common for convertible notes to be modified, or for the date of redemption or repayment to be extended. Regardless as to whether the modification results in the liability being derecognised, or not, this again requires complex calculations. The effective interest rate is likely to change if the modification is deemed substantial.

Conclusion

Accounting for convertible notes is often complex, and even seemingly ‘plain vanilla’ compound convertible notes can involve complex mathematical calculations that are not straightforward.

For entities that enter such funding arrangements, we suggest that detailed analysis and calculations be performed as early as possible, so the financial statement impacts of the funding arrangement can be fully understood by management.

If you need more assistance, please contact us.