Convertible notes - Are you accounting for these correctly (Part 9)?In the current economic climate, we continue to see different types of convertible note arrangements, typically entered into by companies needing to offer attractive returns in order to obtain funds from lenders and investors.
Over the past few months we have been looking at some practical aspects regarding accounting for convertible notes, including:
- An overview of the requirements (in the April 2018 edition of Accounting Alert)
- A detailed example of a convertible note classified as a compound financial instrument (in the May 2018 edition of Accounting Alert)
- A detailed example of a convertible note with an embedded derivative liability (in the mid-June edition of Accounting Alert)
- Common scenarios encountered in practice where conversion features either meet or fail equity classification (in the July 2018 edition of Accounting Alert)
- A detailed example of a convertible note converting into a variable number of shares based on the issuer’s share price at conversion date (in the August 2018 edition of Accounting Alert).
- A detailed example of a convertible note issued in a currency other than the issuer’s functional currency (in the September 2018 edition of Accounting Alert).
- A detailed example of a convertible note with a feature that allows the issuer to repay (call) the note early (in the October 2018 edition of Accounting Alert).
- A detailed example of a convertible note with an early repurchase option (in the November 2018 edition of Accounting Alert).
In some circumstances, convertible notes mandatorily convert after a fixed period of time, but pay a contractual coupon up to the point of conversion. Provided that the conversion feature results in the conversion of a fixed functional currency amount of the notes into a fixed number of shares, the conversion feature of the mandatorily convertible component is classified as equity.
The liability component consists only of the cash flows associated with the contractually required coupon payments. This treats the note effectively as prepaid equity and results in significantly more equity upon initial recognition than would be the case with a conventional convertible note with a conversion option. Interest expense recognised at the effective interest rate would also be significantly lower than a conventional convertible note.
Example: Mandatorily convertible note
ABC Limited issues a convertible note with a face value of $1,000,000.
The note matures three years from its date of issue and pays a 10% annual coupon.
On maturity, the note mandatorily converts into 1,000,000 ordinary shares of ABC Limited.