Financial liabilities IAS39 help needed

Gill Gittings

Hi
Can someone help me with this issue please it's in relation to the separation of a callable convertible bond.

Company issues 600,000 callable bonds at the start of yr 1. They are issued at par value of £100 per bond. The bonds are convertible by the holder into a fixed number of shares at any time after the 1st anniversary of the issue. They don't have a fixed maturity because the holders can redeem the bond at anytime at an amount equal to the fixed capital.

I've got the value of the bond without the option as £57 million and the value of the call option as £2 million and I'm trying to separate them out but have hit a stumbling block.

Anyone able to help?

Steve Collings

What a complex question for a Friday!!

The £2m call option is a non-equity derivative financial instrument and must also be included in the liability portion of the instrument. The inclusion of this will result in the value of a callable bond WITHOUT the equity conversion provision to be less than the value of the straight bond (you may have heard straight bonds termed 'plain vanilla' bonds). This is because the issuer's right to call in the bond if interest rates go up and the bond price increases will make the value of the callable bond less attractive to the holder of the bond as opposed to a plain vanilla bond

Therefore the value of the callable bond (your liability component) is £55m and the value of the equity element is basically the balance of £5m.

You're using IAS 39 which is darn complicated at the best of times! Because the liability component will contain the call option you'll need to assess whether the call option is closely related to the host debt instrument. I think because the call option's exercise price is set at £60m (which is the fixed stated capital element of the bond) at each exercise date the option's exercise price of £60m is likely to be more or less equal to the amortised carrying amount of the bond plus the equity conversion. As such the call option IS closely related to the host debt instrument so you won't separately account for the call option, you'll keep it in with the liability portion of the instrument. On the other hand, if the exercise price of the call option were set at an amount not more or less equal to the debt instrument's amortised carrying amount you would account for the call option separately and the way you would do it is to say:

Debit cash £60m
Debit derivative asset (call option) £2m
Credit financial liability (host debt instrument) £57m
Credit equity £5m

But I've digressed there!! The £55m liability has to be measured under IAS 39 as either a financial liability at fair value through profit or loss, or as another liability measured at amortised cost using the effective interest rate method. However, in your situation I would say that because the bond can be called by the holder at any time, or converted by the issuer at any time after the first anniversary of its issue, the liability portion of £55m is not automatically increased to its redemption amount of £60m because the effective interest rate method requires you to discount the cash flows over the instrument's expected life and in doing this you'll take into consideration all the financial instrument's contractual terms and this period might well be more than one year! The separation of the call option won't affect the equity component of the transaction - only the liability aspect of it. The derivative asset will be measured at fair value at each balance sheet date until the option expires and your liability component is amortised over its expected useful under the effective interest rate method.

Hope that little lot helps.

Cheers

Steve

Gill Gittings

Steve thank you soooo much! You are a star:) x