The liability first, equity as the residual

Learning objectives

• Calculate the liability component by discounting the cash flows at the rate of a similar liability without a conversion option, then the residual equity component.L2
• Justify the choice of the liability discount rate as a judgement input of the case, not as a rate imposed by the Standard.L3

Normative references

• IAS 32 §31IFRS 9 deals with the measurement of financial assets and financial liabilities. When the initial carrying amount of a compound instrument is allocated, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component; embedded derivatives other than the equity component (for example, a call option) are included in the liability component; the sum of the two components on initial recognition is always equal to the fair value of the instrument as a whole, and no gain or loss arises from initially recognising the components separately.
• IAS 32 §32Under the approach in para. 31, the issuer of a convertible bond first determines the carrying amount of the liability component at the fair value of a similar liability (including any embedded non-equity derivative features) that has no associated equity component; the equity component, represented by the conversion option, is then determined by deducting that fair value from the fair value of the compound instrument as a whole.

Original summaries of the paragraphs (reference register), never a quotation of the standard.

3 questions

• Dalia SA issues on 1 January, at par, bonds convertible into a fixed number of shares: proceeds of {issue_proceeds}, repayment at par in {term_years}, annual coupon of {annual_coupon} paid at the end of each year. Case data, from management's judgement: a similar debt without a conversion option would be issued at a rate of {discount_rate} (a rate not imposed by the standard). Calculate, one flow at a time, the present value of the principal and of each of the three coupons, then the liability component and the residual equity component.L3
• A colleague describes the steps of the initial split of a convertible bond. Which of the colleague's sentences is wrong?L2
• Opéra SA issues bonds convertible into a fixed number of shares, with a 3% coupon. Case facts: an ordinary loan of the same term and ranking and with no conversion option would be financed at 6.5%; the risk-free rate is 2%; shareholders expect a return of 11%. Which rate does management use to discount the cash flows of the liability component?L3