We provide a comprehensive guide on how to account for these financing tools.
Convertible notes are a common financing tool for Natural Resources businesses to fund their operations. They allow debt to be converted into equity, giving investors a share in potential equity growth. They also often provide a cash settlement option to protect against downside risks when the conversion is ‘out of the money’.
Convertible instruments typically consist of a loan and an equity conversion option. But some are more complex, and this affects the accounting approach. While conversion options may be settled with equity shares, they are not always classified as equity. Depending on their terms, they may be treated as derivatives, measured at fair value, with fluctuations impacting profit or loss.
Sometimes convertible notes contain embedded derivative features, such as when the conversion price is variable. This means the conversion option is classified as a derivative liability. This is common when the number of shares issued is based on factors such as market price variability or performance targets, rather than being a fixed number of shares.
Key definitions per IAS 32
Financial liabilities is defined as:
- A contractual obligation:
- to deliver cash or another financial asset to another entity, or
- to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity, or
- A contract that will or may be settled in the entity’s own equity instruments and is:
- a non–derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments, or
- a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments
Equity is defined as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
An equity instrument is defined as:
- The instrument includes no contractual obligation:
- to deliver cash or another financial asset to another entity, or
- to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer.
- If the instrument will or may be settled in the issuer’s own equity instruments, it is:
- a non–derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments, or
- a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments
A derivative is defined as a financial instrument with all three of the following characteristics:
- Its value changes in response to the change in a specified, financial instrument price, commodity price, foreign exchange rate,
- It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- It is settled at a future date.
Classification of convertible notes
For accounting purposes, convertible notes fall under IAS 32 and IFRS 9. These standards require a detailed analysis of the terms of the instrument, with each component separately classified as either a financial liability or equity.
IAS 32 mandates that a convertible instrument is treated as having two components: a liability host and a conversion feature, which may or may not qualify as equity. If there are multiple components, they must be analysed individually to decide the correct classification.
A financial liability arises when an entity is contractually obliged to deliver cash or another financial asset, or to exchange financial assets or liabilities under potentially unfavourable conditions.
Where an entity has a contractual obligation that will or may require settlement in the entity’s own equity instruments, the liability classification requirements differ for non-derivatives and derivatives:
- Non-derivative contracts that deliver a variable number of shares are classified as financial liabilities. This is because the company doesn’t have control over the number of shares it will issue
- Derivative contracts (such as conversion options in convertible notes) are classified as financial liabilities unless they meet the fixed-for-fixed criterion under IAS 32.
On the other hand, equity instruments are those where the issuer has no obligation to deliver cash or another financial asset, and the settlement involves issuing a fixed number of shares for a fixed amount of cash (commonly referred to as the fixed-for-fixed criterion).
Conversion features in convertible notes (which are often derivatives) can only be classified as equity if they meet the fixed-for-fixed criterion. If not, they are considered derivative liabilities.
Measurement principles
Once the classification of the components of a financial instrument is decided, the next step is to measure each part.
Compound financial instrument
For a convertible instrument classified as containing both a liability and equity component, the liability is measured first by calculating the present value of future cash flows. It is then discounted using the interest rate applicable to an equivalent instrument without the conversion feature (ie a standard loan).
The equity component is the residual value, calculated by subtracting the liability value from the instrument’s total fair value. This approach aligns with the definition of equity as a residual interest.
In most cases, the instrument’s fair value at initial recognition is the transaction price unless it is quoted in an active market or, if issued for non-monetary consideration, where the fair value of the whole instrument may need to be determined. After initial recognition, the liability is measured at amortised cost, while the equity component is not remeasured.
Convertible note with embedded derivative liability
When a convertible note has a conversion feature classified as a derivative liability, this is accounted for separately from the host instrument under IFRS 9. This applies when the economic characteristics of the embedded derivative differ significantly from those of the host debt instrument. It means the derivative must be separated, unless the entire instrument is measured at fair value through profit or loss (FVTPL). In this case, the derivative’s fair value is calculated first, with the remaining value assigned to the liability component.
After initial recognition, the derivative liability is measured at fair value through profit or loss, while the host liability is accounted for at amortised cost.
Alternatively, under IFRS 9, an entity can choose the fair value option to account for the entire contract, simplifying the accounting process. It is worth noting that doing so potentially increases volatility in reported profit or loss if factors like interest rates or the issuer’s credit rating change.
Examples – Mining companies
| Example 1 – Convertible into a fixed number of shares Background: A UK-based mining company, EnergyCo, issues a £1,000 convertible note to fund the development of a new mining project. The note has a three-year maturity and pays a 10% annual coupon. At maturity, the holder can either receive £1,000 in cash or convert the note into 5,000 shares of EnergyCo. The market interest rate for a similar non-convertible note would have been 12%. EnergyCo also incurred £100 in transaction costs. Classification: The convertible note is assessed for classification under IFRS: Liability component: The obligation to pay the 10% annual coupon and the £1,000 principal is classified as a liability because EnergyCo has a contractual obligation to deliver cash. Equity component: The option to convert the £1,000 into 5,000 shares is classified as equity since it meets the fixed-for-fixed criterion (a fixed amount of cash is exchanged for a fixed number of shares). Measurement: The liability component is initially measured at the present value of future cash flows, discounted using the market interest rate of 12% (the rate applicable to a non-convertible instrument). The equity component is measured as the residual amount, calculated by deducting the liability’s fair value from the total transaction price (£1,000). |
| Example 2 – Convertible note with an embedded derivative liability Background: MetalsCo, another UK mining company, issues a £1,000 convertible note. The note matures in three years, pays a 10% annual coupon, and allows the holder to convert the note into shares of MetalsCo. The conversion price is variable, based on the lowest 5-day average share price in the 30 days prior to conversion. Transaction costs of £100 were incurred. Classification: – Liability component: The cash repayment of the £1,000 principal and coupon payments is classified as a liability. – Derivative liability component: The conversion option, because it is settled with a variable number of shares – conversion price is based on a variable – the lowest 5-day average share price, which fails the fixed-for-fixed criterion. Therefore, the conversion option is classified as a derivative liability rather than equity. Measurement: – The derivative liability is measured first at its fair value (determined to be £50). The residual value of £950 (£1,000 minus £50) is allocated to the host liability. – Transaction costs are apportioned between the liability and the derivative, with £95 allocated to the liability and £5 expensed immediately as it relates to the derivative. |
Disclosure and presentation
Financial statement disclosures for convertible notes are guided by IFRS 7 and IFRS 9.
Presentation in financial statements: Convertible notes should be classified and disclosed based on whether they are liabilities, equity, or a combination of both. The equity component, if applicable, is often recognised as a residual after measuring the liability component at its fair value.
Fair value measurement: Convertible notes with embedded derivatives or those measured at fair value through profit or loss (FVTPL) require disclosure of fair value inputs and any changes that affect the issuer’s credit risk. IFRS 13 requires extensive disclosures regarding fair value, including categorising inputs in a three-level hierarchy:
- Level 1: Quoted prices in active markets
- Level 2: Observable inputs other than quoted prices
- Level 3: Unobservable inputs.
Credit and liquidity risks: Disclosures must include information on how the issuer manages credit risk, liquidity, and exposure to financial risks arising from convertible notes. This includes details on how credit risk may affect the convertible instruments’ value.
Current versus non-current classification: The classification of the convertible note between current and non-current liability is based on the issuer’s right to defer settlement for at least 12 months and whether the liability can be settled by issuing equity. Recent amendments to IAS 1 clarify how these should be treated, especially for financial liabilities that have equity conversion features.
If you would like further support on any of the issues raised in this article, please contact Nick Joel or Lakshmi Upadhyaya.
