The pitfalls of contract design

There has been an increase in mezzanine forms of financing in the wake of the Covid pandemic. These include not only profit participation rights and silent partnerships, but also bonds and debentures with extended conversion rights. In this article, we will discuss the different accounting consequences of convertible bonds and convertible debentures under IFRS, as a function of the contractual structure of these instruments. Here, particular attention is paid to the terms of the conversion rights and any existing interdependencies between different conversion rights, which in aggregate (may) have a significant impact on the key balance sheet figures.  

As a rule, convertible bonds and convertible debentures are a combination of a traditional bond or debenture plus an option to be converted into treasury shares, for example. One common structure is the option to convert the bond or debenture after a certain blocking period and/or at maturity. When converted into treasury shares, the issue of a convertible bond or debenture is always subject to a resolution of the Annual General Meeting (the granting of the conversion right implies a conditional capital increase). As such, a convertible bond combines the characteristics of bonds/debentures and shares, offering the issuer the advantage that debt capital can be raised at a comparatively lower interest rate. By means of the conversion right, the creditors have the advantage of being able to participate in share price performance or increases in the value of the company. 

Along with the classic contractual structure, convertible bonds or debentures can be configured in a wide variety of ways regarding the conversion rights, which can lead to a classification as either a compound financial instrument or a hybrid financial instrument from an accounting perspective. 

With a compound financial instrument, there is an equity component alongside a financial liability. Accordingly, provided a convertible bond or debenture is to be classified as a compound financial instrument, the conversion right must be structured in line with the characteristics of an equity instrument. For the conversion right to be classified as an equity instrument, it must meet the so-called "fixed-for-fixed" criterion. The fixed-for-fixed criterion requires that a fixed amount of cash or another financial asset (in this case, the convertible bond or debenture) be exchanged for a fixed number of equity instruments, for example shares. In addition, no options for the settlement of conversion rights may conflict with the classification as an equity instrument – such as a net settlement (cf. IAS 32.16(b) in conjunction with IAS 32.22). Clauses included for reasons of protection against dilution regarding the conversion right do not lead to classification as an equity instrument only if they are structured in a certain way; nonetheless, the effects should be evaluated.

By contrast, hybrid financial instruments are a combination of a debt instrument with one or several (embedded) derivatives that may be required to be separated. Unless the conversion right is structured in such a way that it meets the requirements for classification as equity, it is not a compound financial instrument, but as a rule a hybrid financial instrument with the conversion right as an embedded derivative (see IFRS 9.4.3.1).¹

For a compound financial instrument, initial recognition is determined based on the individual components in the following manner. The debt component (borrowed capital) is recognized at the fair value of a comparable instrument without conversion rights, with due consideration given to the entity's (own) credit risk. The compound financial instrument's issue proceeds correspond to the fair value of the entire financial instrument consisting of the debt component and the conversion right. Any difference between the determined fair value of the debt component and the issue proceeds is attributed to the conversion right (residual value method). The debt component is therefore a financial liability within the scope of IFRS 9 and is subsequently measured at amortized cost using the effective interest method. On the other hand, the conversion right represents an equity instrument, lies outside the scope of IFRS 9 and must not be taken into account further in the context of subsequent valuation. Likewise, transaction costs incurred are to be taken into account insofar as they are directly attributable to the financial instrument (cf. IFRS 9.A). It should be noted with regard to the transaction costs of compound financial instruments that these are to be allocated proportionately to the respective components (debt and equity instruments) in the ratio of their debt and equity components. 

From a financial accounting perspective, the design as a compound financial instrument entails the advantage of greater predictability of the income statement. Owing to the debt component being accounted for at amortized cost under IFRS 9 and the classification of the conversion right as an equity instrument outside the scope of IFRS 9, the effects can be anticipated to a large extent in the income statement. Without more extensive fair value measurement, it is also not necessary to implement a more complex measurement model and corresponding disclosures in the notes on financial instruments measured at fair value (in particular fair value hierarchy level 3). One drawback to the issue of a compound financial instrument is that it always involves the issue of new shares and a dilution of the existing shareholder structure. Where applicable, further anti-dilution clauses must also be taken into account.  

Unless the conversion right meets the fixed-for-fixed criterion or the settlement method provides for gross settlement, the conversion right does not constitute an equity instrument from an accounting perspective. As a result, the financial instrument ceases to be a compound financial instrument and is instead regularly recognized as a hybrid financial instrument (cf. IFRS 9.4.3.1).² In this case, the conversion right represents an embedded derivative, which is regularly subject to a separation requirement (in the case of financial liabilities; this does not apply to the recognition of financial assets). Whether an embedded derivative qualifies for separation depends largely on the embedded derivative's economic opportunities and risks and whether these are closely or not closely related to the underlying contract's economic opportunities and risks. Apart from the relationship between the economic opportunities and risks, the conversion right for a separation obligation must fulfill the general conditions of a derivative and the contract as a whole may not (voluntarily) be accounted for at fair value through profit or loss (cf. IFRS 9.4.3.3).

A hybrid financial instrument is recognized in the same way as a compound financial instrument, i.e., on the basis of the contract's individual components. Unlike the recognition of the debt component at fair value, however, for hybrid financial instruments the fair value of the embedded derivative (which must be separated) must be determined and recognized initially. Then, the value of the debt component represents the residual and is calculated as the difference between the value of the entire combined instrument and the value of the embedded derivative in accordance with IFRS 9.B4.3.3. With regard to subsequent measurement, both the debt component and the embedded derivative fall within the scope of IFRS 9. The debt component is usually allocated to the valuation category at amortized cost in accordance with IFRS 9, while the embedded derivative is to be allocated to the valuation category at fair value through profit or loss.

In contrast to compound financial instruments, hybrid financial instruments have the opposite advantages and disadvantages with regard to their impact on the balance sheet. In view of the classification of the conversion right as a derivative financial instrument, the measurement of the conversion right through profit or loss means that the effects on the income statement are difficult to predict; only the effects from the recognition of the liability component can be reliably forecast. All in all, the measurement of the conversion right through profit or loss is expected to result in higher volatility in the income statement. Furthermore, the embedded derivative's measurement through profit or loss requires implementing a valuation model so that the fair value can be reliably calculated at each balance sheet date. Depending on the issuing entity, the fair value of the conversion right may also have to be determined using a method that corresponds to fair value hierarchy level 3, resulting in more extensive and very comprehensive disclosure requirements (see IFRS 13.93(d)-(i)). One advantage of hybrid financial instruments is that since no new shares are issued, there is no dilution of the shareholder structure. 

With a view to eliminating the accounting consequences of structuring the conversion right as a derivative financial instrument, it may be considered from a risk management perspective to conclude an offsetting option on the company's equity instruments. To the extent that the option is structured as a mirror image of the included conversion right, the negative effects of the mandatory recognition of the conversion right at fair value in the income statement can be almost completely offset. Particular attention must be paid here to the contractual structure so as to achieve a largely complete offsetting of the changes in value in the income statement (so-called equity neutral convertible bond). The hedging strategy is already reflected in the mandatory fair value measurement of the two derivatives from an accounting perspective, so no further application of specific accounting requirements such as hedge accounting under IFRS is necessary.

Aside from the design of convertible bonds or debentures with a single conversion right, the design features may also provide for further (separable) embedded derivatives. These include, for instance, voluntary conversion or contingent mandatory conversion depending on the occurrence of certain events. The occurrence of a mandatory conversion is often linked to certain events, such as an IPO. The respective features of the options can also be combined in one contract. Particular attention must be paid in this context to the design of the respective option clauses. Whenever a contract contains multiple embedded derivatives, each of these must be examined to determine whether they are required to be separated. As a rule, several embedded derivatives must be treated as a single compound embedded derivative if they are subject to the same risk or are dependent on each other (single compound embedded derivative). However, if the embedded derivatives relate to different risks and are independent of each other, they must be recognized separately (cf. IFRS 9.B4.3.4). 

It is important to bear in mind that, depending on the contractual arrangement, a conversion right that is supposed to be classified as equity may be affected by other features (e.g., a net settlement option or other conversion rights not to be classified as equity), so that the conversion right alone does not represent a stand-alone equity instrument, but rather a financial liability (or a financial asset) that may have to be recognized together with other embedded derivatives as a single compound embedded derivative under certain conditions. For this reason, when drafting the contract, particular attention should be paid to the design of any embedded derivatives in order to achieve the desired accounting treatment. 

It is recommended that you discuss this with your advisor and/or auditor. The members of our Finance and Treasury Management Team will be pleased to assist you.

Source: KPMG Corporate Treasury News, Edition 122, June 2022
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Björn Beckmann, Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG

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¹⁺² Based on the assumption that the respective criteria for one of the embedded derivatives are met.