COMPOUND FINANCIAL

INSTRUMENTS
At the end of the topic, you should be able to:
1. To define a financial instrument.
2. To describe a financial liability and an equity instrument.
3. To define a compound financial instrument.
4. To identify common forms of compound financial instrument.
5. To know the accounting for a compound financial instrument.
Financial Instrument – Definition & Characteristics
Definition
Any contract that gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.

Characteristics
1. There must be a contract.
2. At least two parties to the contract.
3. Gives rise to a financial asset of one party and financial liability or equity
instrument of another party.
Financial Instrument – Definition & Characteristics

Please note that unlike other assets or liabilities, financial instruments arise from
the CONTRACT.
Types of Financial Instruments

Stocks and bonds are common examples of Cash Financial

Instruments.
Financial Liability - Definition
A contractual obligation:
1. To deliver cash or other financial asset to another entity.

Examples: Trade Accounts Payable, Notes Payable, Loans Payable

Bonds Payable

2. To exchange financial instruments with another entity under conditions

that are potentially unfavorable.
Examples: Written Call Options & Written Put Options
Examples of Nonfinancial Liabilities
1. Deferred Revenue & Warranty Obligations
Reason: The obligation is the delivery of goods and services.

2. Income Tax Payable

Reason: Arises from law, not contract.

3. Constructive Obligations
Reason: Do not arise from contracts.
Equity Instruments
✓ Any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.

Examples:
1. Ordinary Share Capital
2. Preference Share Capital
3. Warrants or Options
Financial Liability or Equity Instrument?
The main question to respond when classifying an instrument as either a
financial liability or an equity instrument is:
Compound Financial Instruments
A financial instrument that contains both a liability and an equity element
from the perspective of the issuer.

Examples:
1. Bonds with share warrants.
2. Convertible bonds.

These financial instruments have both liability and equity component.

Accounting for Compound Financial Instruments
✓ PAS 32 mandates that the liability and equity components shall be
accounted for separately through an approach called split accounting.

✓ Under split accounting, the consideration received is allocated between the

liability and equity components.

How to apply Split Accounting?

✓ The fair value of the liability component is first determined.
✓ The residual amount is allocated to the equity component.
Accounting for Compound Financial Instruments

Total Consideration XX
Less: Fair Value of the liability component XX
Amount allocated to the equity component XX
Bonds Payable with Share Warrants
✓ Share warrants represent the right to acquire shares of the issuing entity at
a specified price at some future time.

✓ Share warrants may be detachable or not. Detachable warrants can be

traded separately.

✓ The share warrants, regardless if detachable or not, shall be accounted for

separately.
Bonds Payable with Share Warrants
Allocation of Issue Price

Total Consideration XX
Less: Fair Value of the liability component XX
Amount allocated to the equity component XX

Note: In the absence of the market value of bonds without the warrants, the
amount allocated to the bonds payable is equal to the present value of the
bonds using an effective interest rate for similar bonds payable without the
warrants.
Example # 1: Bonds Payable with Share Warrants
On January 1, 2022, Natan Company issued 500 of its 5 year, 10% P1,000 face value
bonds at 112. Each bond includes a warrant that allows the holder to purchase 20
ordinary shares with par value P100 at P110 per share. Interest is payable annually
every December 31 of each year.

Requirements:
Case 1: The market value of the bonds ex-warrant at the time of issuance is 98.
Case 2: The market value of the bonds ex-warrant at the time of issuance is 105.
Case 3: The prevailing market rate of interest for similar bonds without the
warrants is 12%.
Answer # 1: Bonds Payable with Share Warrants
Case 1: The market value of the bonds ex-warrant at the time of issuance is 98.

Total Consideration (500k x 1.12) 560,000

Less: Fair Value of the liability component (500k x 0.98) 490,000
Amount allocated to the equity component 70,000

Journal Entry: Cash 560,000

Discount on Bonds 10,000
Bonds Payable 500,000
Share warrants outstanding 70,000*
* Share warrants outstanding is an equity item under Share Premium.
Answer # 1: Bonds Payable with Share Warrants
Case 2: The market value of the bonds ex-warrant at the time of issuance is 105

Total Consideration (500k x 1.12) 560,000

Less: Fair Value of the liability component (500k x 1.05) 525,000
Amount allocated to the equity component 35,000

Journal Entry: Cash 560,000

Bonds Payable 500,000
Premium on bonds payable 25,000
Share warrants outstanding 35,000
Answer # 1: Bonds Payable with Share Warrants
Case 3: The prevailing market rate of interest for similar bonds without the warrants
is 12%. (Round PV Factors to 4 decimal places)

Total Consideration (500k x 1.12) 560,000

Less: Fair Value of the liability component* 463,940
Amount allocated to the equity component 96,060

Journal Entry: Cash 560,000

Discount on bonds payable 36,060
Bonds Payable 500,000
Share warrants outstanding 96,060
Answer # 1: Bonds Payable with Share Warrants
Case 3: The prevailing market rate of interest for similar bonds without the warrants
is 12%. (Round PV Factors to 4 decimal places)

* Present Value of face amount (500k x 0.5674) 283,700

Present Value of interest payments (50k x3.6048) 180,240
Amount to be assigned to bonds 463,940
Example # 2: Bonds Payable with Share Warrants
On January 1, 2022, Natan Company issued 500 of its 5 year, 10% P1,000 face value
bonds at 112. Each bond includes a warrant that allows the holder to purchase 20
ordinary shares with par value P100 at P110 per share. Interest is payable annually
every December 31 of each year. The market value of the bonds ex-warrant at the
time of issuance is 98.

Requirement:
1. Journal entry to record exercise of all warrants.
2. Journal entry to record exercise of 60% of warrants, remaining expired.
Answer # 2: Bonds Payable with Share Warrants
Requirement 1: All warrants were exercised.
1 bond = 1 warrant
1 warrant = 20 ordinary shares @110 per share
500 warrants = 10,000 ordinary shares @ 110 per share

To record exercise of warrants:

Cash (10,000 x 110) 1,100,000
Share warrants outstanding 70,000
Ordinary Share Capital 1,000,000
Share premium 170,000*
Answer # 2: Bonds Payable with Share Warrants
Requirement 1: All warrants were exercised.

* Total cash received from exercising the warrants 1,100,000

Add: Share warrants exercised 70,000
Total 1,170,000
Less: Total par value of shares issued (1,000,000)
Share Premium 170,000
Answer # 2: Bonds Payable with Share Warrants
Requirement 2: 60% warrants were exercised, 40% expired.
1 bond = 1 warrant
1 warrant = 20 ordinary shares @110 per share
300 warrants = 6,000 ordinary shares @ 110 per share

To record exercise of warrants:

Cash (6,000 x 110) 660,000
Share warrants outstanding (70k x 60%) 42,000
Ordinary Share Capital 600,000
Share premium 102,000*
Answer # 2: Bonds Payable with Share Warrants
Requirement 2: 60% warrants were exercised, 40% expired.

* Total cash received from exercising the warrants 660,000

Add: Share warrants exercised 42,000
Total 702,000
Less: Total par value of shares issued (600,000)
Share Premium 102,000

To record expired warrants:

Share warrants outstanding 28,000
Share Premium 28,000
Convertible Bonds
✓ Bond that can be exchanged into shares or other securities of the issuing
entity within a specified period of time.

Reason of issuing Convertible Bonds?

✓ To make the bonds more attractive to investors.
✓ The conversion privilege, often, becomes less attractive as time goes by.

How to Account for Convertible Bonds?

✓ The conversion privilege should be accounted for separately as equity.
Convertible Bonds

A call option is a contract between a buyer and a seller to purchase a certain stock at a certain
price up until a defined expiration date.
Convertible Bonds
Allocation of Issue Price

Total Consideration XX
Less: Fair Value of the liability component XX
Amount allocated to the equity component XX

Note: In the absence of the market value of bonds without the conversion
privilege, the amount allocated to the bonds payable is equal to the present
value of the bonds using an effective interest rate for similar bonds payable
without the warrants.
Knowledge Check!
Up to when should we amortize premium, or discount related to convertible
bonds?
1. Up to date of maturity? Or
2. Up to conversion date?

Answer: The amortization table will be prepared up to the date of maturity

because it is impossible to predict if, at all, the conversion privilege will be
exercised.
Example # 3: Issuance of Convertible Bonds
On January 1, 2022, Beatrix Company issued 500 of its 5-year, 10% P1,000 face
value convertible bonds at 112. Each bond is convertible into 20 ordinary shares
with par value of P100 per share. Interest is payable annually every December 31 of
each year.

Requirements:
Case 1: The market value of the bonds without the conversion privilege at the time
of issuance is 98.
Case 2: The market value of the bonds without the conversion privilege at the time
of issuance is 105.
Case 3: The prevailing market rate of interest for similar bonds without the
conversion privilege is 12%.
Answer # 3: Issuance of Convertible Bonds
Case 1: The market value of the bonds ex-warrant at the time of issuance is 98.

Total Consideration (500k x 1.12) 560,000

Less: Fair Value of the liability component (500k x 0.98) 490,000
Amount allocated to the equity component 70,000

Journal Entry: Cash 560,000

Discount on Bonds 10,000
Bonds Payable 500,000
Share premium- conversion privilege 70,000*
* Conversion Privilege is an equity item under Share Premium.
Answer # 3: Issuance of Convertible Bonds
Case 2: The market value of the bonds ex-warrant at the time of issuance is 105

Total Consideration (500k x 1.12) 560,000

Less: Fair Value of the liability component (500k x 1.05) 525,000
Amount allocated to the equity component 35,000

Journal Entry: Cash 560,000

Bonds Payable 500,000
Premium on bonds payable 25,000
Share premium- conversion privilege 35,000
Answer # 3: Issuance of Convertible Bonds
Case 3: The prevailing market rate of interest for similar bonds without the
conversion privilege is 12%. (Round PV Factors to 4 decimal places)

Total Consideration (500k x 1.12) 560,000

Less: Fair Value of the liability component* 463,940
Amount allocated to the equity component 96,060

Journal Entry: Cash 560,000

Discount on bonds payable 36,060
Bonds Payable 500,000
Share premium- conversion privilege 96,060
Answer # 3: Issuance of Convertible Bonds
Case 3: The prevailing market rate of interest for similar bonds without the
conversion privilege is 12%. (Round PV Factors to 4 decimal places)

* Present Value of face amount (500k x 0.5674) 283,700

Present Value of interest payments (50k x3.6048) 180,240
Amount to be assigned to bonds 463,940
Actual Conversion of Convertible Bonds
Procedures:
1. Update the carrying amount of the bonds by updating the amortization of
the premium or discount, including bond issue costs, to the date of
conversion.
2. The face amount of the bonds converted shall be cancelled together with
the related unamortized premium or discount and bond issue costs.
Knowledge Check!
What if only a portion of bonds is converted?

Answer: The unamortized premium or discount and issue costs shall be

cancelled proportionately.

What if conversion is not made at interest dates?

Answer: The accrued interest is normally paid. However, if not paid, it is

added to the face amount of the bonds payable converted to get the carrying
amount of the bonds payable for conversion purposes. The accrued interest is
charged to interest expense.
Additional Notes
✓ Any cost incurred in connection with the bond conversion shall be charged
to the share premium arising from bond conversion or debit to “share issue
cost”.

✓ No gain or loss on conversion shall be recognized on the conversion of the

bonds.
Example # 4: Actual Conversion of Convertible Bonds
You are provided the following selected accounts as of year-end:
12% convertible bonds payable P2,500,000
Premium on bonds payable 100,000
Share capital, P40 par 5,000,000
Share Premium 1,500,000
Bond conversion privilege outstanding 250,000
Each P1,000 face value bond is convertible into 20 ordinary shares. Interest on the bonds is
fully paid as of year-end. Cost incurred with the conversion amounted to P50,000 and
accrued interest on the bonds on the date of conversion is P75,000 which is paid in cash.
Requirements:
Case 1: All bonds are converted into ordinary shares.
Case 2: 60% of the bonds were converted into ordinary shares.
Answer # 4: Actual Conversion of Convertible Bonds
Case 1: All bonds are converted into ordinary shares.
1 bond = 20 shares
2,500 bonds = 50,000 shares

Bonds converted (2,500,000 x100%) 2,500,000

Add: Related premium on bonds (100,000 x 100%) 100,000
Add: Bond conversion privilege exercised 250,000
Total 2,850,000
Less: Total par value of shares issued (50,000 x 40) (2,000,000)
Share Premium 850,000
Answer # 4: Actual Conversion of Convertible Bonds
Case 1: All bonds are converted into ordinary shares.
To record conversion:
Bonds Payable 2,500,000
Premium on bonds payable 100,000
Share premium – conversion privilege 250,000
Interest Expense 75,000
Ordinary Share Capital 2,000,000
Share premium - issuance 850,000
Cash 75,000
To record conversion costs
Share premium – issuance 50,000
Cash 50,000
Answer # 4: Actual Conversion of Convertible Bonds
Case 2: 60% of the bonds were converted into ordinary shares.
1 bond = 20 shares
1,500 bonds = 30,000 shares

Bonds converted (2,500,000 x 60%) 1,500,000

Add: Related premium on bonds (100,000 x 60%) 60,000
Add: Bond conversion privilege exercised (250k x 60%) 150,000
Total 1,710,000
Less: Total par value of shares issued (30,000 x 40) (1,200,000)
Share Premium 510,000
Answer # 4: Actual Conversion of Convertible Bonds
Case 2: 60% of the bonds were converted into ordinary shares.
To record conversion:
Bonds Payable 1,500,000
Premium on bonds payable 60,000
Share premium – conversion privilege 150,000
Interest Expense 50,000
Ordinary Share Capital 1,200,000
Share premium - issuance 510,000
Cash 75,000
To record conversion costs
Share premium – issuance 50,000
Cash 50,000
Settlement of Convertible Bonds
At maturity date:
✓ Retirement price is just equal to face value of the bonds.
Bonds Payable XX
Interest Expense
Cash XX

✓ Any remaining balance in the bond conversion privilege outstanding

account will be transferred to share premium.
Bond conversion privilege XX
Share premium XX
Settlement of Convertible Bonds
Prior to maturity date:
✓ Retirement price is allocated to the liability and equity component using the
residual approach.

✓ Retirement Price allocated to liability component is compared to the

carrying amount of the bonds to determine gain or loss on retirement.
Retirement Price > Carrying Amount, Loss on Bond Retirement
Retirement Price < Carrying Amount, Gain on Bond Retirement
Example # 5 : Payment of Convertible Bonds
You are provided the following selected accounts as of year-end:
12% convertible bonds payable P2,500,000
Premium on bonds payable 100,000
Share capital, P40 par 5,000,000
Share Premium 1,500,000
Bond conversion privilege outstanding 250,000
Interest is fully paid as of year-end. The convertible bonds are not converted but fully paid
at current year-end for P2,700,000. As of the same date, the quoted price of the bonds
without the conversion privilege is 102.

Requirements:
Determine the gain or loss on retirement of bonds.
Answer # 5 : Payment of Convertible Bonds
Fair Value of the bonds without the conversion privilege 2,550,000
Less: Carrying amount of the bonds, 12/31 2,600,000
Gain on retirement of bonds 50,000

Journal entry:
Bonds Payable 2,500,000
Premium on bonds payable 100,000
Bond conversion privilege 150,000*
Cash 2,700,000
Gain on retirement of bonds 50,000
Answer # 5 : Payment of Convertible Bonds
* Total amount to be paid to settle the convertible bonds 2,700,000
Less: Fair Value of the bonds without the conversion privilege 2,550,000
Amount allocated to the equity component 150,000

Journal entry to record remaining balance of conversion privilege:

Bond conversion privilege (250k-150k) 100,000
Share Premium
 REFERENCES
Intermediate Accounting (Volume Two) 2021 Edition by Valix, Peralta & Valix.

Intermediate Accounting 2, 2022 Edition by Millan, Zeus Vernon.

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