Convertible debt continues to be a challenging area for financial statement preparers.
It involves navigating technically complex accounting standards, and small differences to the wording of a contract can result in a significantly different accounting treatment. This paper aims to explain the principles involved in accounting for convertible debt, and also to highlight some common challenges.
This paper is based upon the requirements of IAS 32 Financial Instruments: Presentation, and IAS 39 Financial Instruments: Recognition and Measurement, which have been issued in Australia as AASB 132 and AASB 139 respectively. A new standard, AASB 9 Financial Instruments, replaces the two existing standards for periods beginning on or after 1 January 2018, but the accounting for convertible debt by issuers will remain unchanged.
Accounting for Convertible Debt
Accounting Treatment: Convertible debt is treated as a compound financial instrument. This means that a ‘split accounting’ approach is adopted, where the debt component and the conversion option are accounted for separately.
The debt component is initially recognised at its fair value. It is then amortised over its life using the effective interest method.
The conversion option may be treated as either equity or as a financial liability. Its treatment will depend on whether it meets what is called the “fixed for fixed” test. In order to be classified as equity, a conversion option must involve a fixed amount of cash being exchanged for a fixed number of equity instruments. If it does not meet this test, it will be classified as a financial liability.
Want to know more information about the accounting treatment? What are some of the common issues with convertible debt?