Using the With-and-without Method in Presenting the Compound Instruments in the Financial Statements

Sometimes issued nonderivative financial instruments contain both liability and equity elements. In other words, one component of the instruments meets the definition of a financial liability and another component of the instrument meets the definition of an equity instrument. Such instruments are referred to as compound instruments.

A common form of compound financial instrument is a debt instrument with an embedded conversion option, such as a bond convertible into ordinary shares of the issuer, and without any other embedded derivative features.

Para. 28 of IAS 32 Financial Instruments : Presentation states that the issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets or equity instruments, as follows :

1. The issuer’s obligation to make scheduled payments of interest and principal is a financial liability that exists as long as the instrument is not converted. On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at the time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option.
2. The equity instrument is an embedded option to convert the liability into equity of the issuer. The fair value of the option comprises its time value and its intrinsic value, if any. This option has value on initial recognition even when it is out of the money.

How to recognize the initial carrying amounts of the liability and equity components of the compound instrument ?

As stated in the : IFRS – Practical Implementation Guide and Workbook, by Abbas Ali Mirza, Magnus Orrell and Graham J.Holt, to determine the initial carrying amounts of the liability and equity components, entities apply the so-called with-and-without method. The fair value of the instrument is determined first including the equity component. The fair value of the instrument as a whole generally equals the proceeds (consideration) received in issuing the instrument. The liability component is then measured separately without the equity component. The equity component is assigned the residual amount after deducting from the fair value of the compound instrument as a whole the amount separately determined for the liability component.

Example :

Entity A issues a bond with a principal amount of $100,000. The holder of the bond has the right to convert the bond into ordinary shares of Entity A. On issuance, Entity A receives proceeds of $100,000. By discounting the principal and interest cash flows of the bond using interest rates for similar bonds without an equity component, Entity A determines that the fair value of a similar bond without any equity component would have been $91,000. Therefore, the initial carrying amount of the liability component is $91,000. The initial carrying amount of the equity component is computed as the difference between the total proceeds (fair value) of $100,000 and the initial carrying amount of the liability component of $91,000. Thus the initial carrying amount of the equity component is $90,000. Entity A makes this journal entry :

Cash	100,000
Financial Liability		91,000
Equity		9,000

Source of this article :

1. IFRS – Practical Implementation Guide and Workbook, by Abbas Ali Mirza, Magnus Orrell and Graham J.Holt (2nd Edition)
2. IAS 32 Financial Instruments : Presentation

A Practical Guide to New IFRSs 2011 (PwC IFRS Publications)

In March 2011, one of the Big 4 accounting firm PricewaterhouseCoopers published its IFRS implementation guidance “A Practical Guide to New IFRSs for 2011”.

Within the 24-page guide book in Q & A format, it provides a high-level outline of the key requirements of new IFRS standards and interpretations that come into effect in 2011. Significant changes to IFRS are due to be published in 2011, but there is a relatively small number of changes that come into effect for 2011 year ends.

One of the significant changes was the IFRS 9, Financial Instruments which was reissued in 2010 to include guidance on financial liabilities and derecognition of financial instruments. This material was relocated from IAS 39, Financial Instruments : Recognition and Measurement, without change, except for financial liabilities that are designated at fair value through profit or loss. The rules on the classification and measurement of financial assets were previously published in the earlier version of IFRS 9. The standard is being added to as the IASB endorses different phases of the project to replace IAS 39. The reissued IFRS 9 applies to 2013 year ends but can be adopted with immediate effect.

Another changes was regarding IFRIC 19, Extinguishing Financial Liabilities with Equity Instruments which comes into effect in 2011.

Two further amendments that have effective dates in 2010 and will impact 2011 year ends. Amendments to IAS 32, Financial Instruments : Presentation, on classification of right issues and amendment to IFRS 1, First-time Adoption of IFRS, on financial instrument disclosures. Amendments that apply from 1 January 2011 include an amendment to IAS 24, Related Party Disclosures, and an amendment to IFRIC 14, IAS 19 – The limit on a defined benefit asset, minimum funding requirements and their interaction.

Download the publication directly from here : A Practical Guide to New IFRSs for 2011