The functional currency FOREIGN EXCHANGE

Chapter 20 – Financial Instruments Page 274

5.2 Compound financial instruments

A compound financial instrument is one that contains both a liability component and an equity component. Such components should be classified separately according to their substance. [IAS 32.28] A compound instrument should be split into its component parts at the date that it is issued. The split should not be revised for subsequent changes in market interest rates, share prices, or other events that change the likelihood that the conversion option will be exercised. A convertible bond is an example of a compound instrument, since it has a debt element and a potential equity element on conversion. The economic effect of issuing the convertible bond is the same as issuing a non-convertible bond and an option to purchase shares. The value of the convertible bond should therefore be split into its component parts to reflect the substance of the instrument. An entity should estimate the fair value of the component parts. The fair value of a similar financial liability that does not have an equity element is used as an estimate of the carrying amount of the liability element, with the equity instrument being the difference between this and the fair value of the compound instrument as a whole. Fair value is the “amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.” [IAS 32.11] If the compound financial instrument is converted, the carrying amount of the financial liability element should be reclassified as part of equity, with the original equity amount also remaining as part of equity. No gain or loss is recognised on conversion of the instrument at its maturity. Illustration 2 An entity issues 3,000 convertible, 10-year bonds at CU100 each, with a nominal interest rate of 5. The fair value of similar 10 year bonds with no convertible element is CU250,000. The conversion details are 100 shares for each bond to be exercised after 5 years but before the redemption date in 10 years time. At the date of issuance of the financial instrument, the following amounts should be recognised: Proceeds of bond issue 3,000 x CU100 CU300,000 Fair value of liability component CU250,000 Equity component CU300,000 less CU250,000 CU50,000 Chapter 20 – Financial Instruments Page 275 6 Treasury Shares If an entity acquires its own shares, they are deducted from equity. Such shares are known as treasury shares. [IAS 32.33] An entity should not recognise any gain or loss made from a transaction involving treasury shares, and any consideration paid or received should be recognised directly in equity. [IAS 32.33] The amount of treasury shares held should be disclosed either in the statement of financial position or in the notes to the financial statements in accordance with IAS 1 Presentation of financial statements. 7 Interest, Dividends, Losses and Gains Where interest, dividends, losses or gains arise in relation to a financial instrument that is classified as a financial liability, they should be recognised in profit or loss for the period. [IAS 32.35] Dividends payable in respect of a financial instrument that is classified as a financial liability are classified as an expense. For example, dividends payable in respect of redeemable preference shares are presented as finance costs in the statement of comprehensive income. They may either be reported as part of interest or presented as a separate line item. Distributions, such as dividends, paid to holders of a financial instrument classified as equity should be charged directly against equity. [IAS 32.35] When equity shares are issued, the transaction costs should be deducted from equity, net of any related income tax benefit. The transaction costs to be deducted are only the incremental costs directly attributable to the transaction that would have been otherwise avoided. [IAS 32.25] Illustration 3 An entity issues 100,000 new CU1 ordinary shares which have a fair value of CU2.50 per share. Professional fees in respect of the share issue are CU50,000. The costs are deductible in arriving at the entity’s income tax liability. The rate of tax is 40. The management of the entity estimates that costs incurred internally for time incurred working on the share issue are CU25,000. The internal costs should be recognised in profit or loss for the period. The professional fees are directly attributable to the transaction and CU30,000 should be deducted from equity CU50,000 net of 40 tax. Equity will increase by CU220,000 100,000 x CU2.50 - CU30,000.