4. Compound Financial Instruments
Sometimes, a single contract contains elements of both debt and equity. These are known as compound financial instruments. A classic example is a redeemable debenture that requires periodic interest payments (a liability) but may also involve the issuance of shares upon maturity (an equity component).
Measurement Principles
Once an instrument is identified, the next step is determining its value. This process is divided into two stages: initial measurement and subsequent measurement.
Initial Measurement
At the moment of inception, all financial instruments are initially measured at Fair Value (FV). Fair value is defined as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. For most instruments, this initial value includes the transaction costs associated with the acquisition or issuance.
Subsequent Measurement of Financial Assets
For financial assets, the method used to value the asset after its initial recognition depends on two critical tests under IFRS 9:
- The Business Model Test: This examines the entity's objective for holding the asset. Is the goal to hold the asset to collect contractual cash flows, or is it to sell the asset to realize fair value changes?
- The Cash Flow Characteristics Test (SPPI): This examines whether the contractual terms give rise to cash flows that are Solely Payments of Principal and Interest (SPPI) on the principal amount outstanding.
Based on these tests, assets are categorized into:
- Amortised Cost: Applied if the asset is held to collect cash flows and meets the SPPI test.
- Fair Value Through Profit or Loss (FVTPL): Applied if the asset is held for trading or if the entity elects the Fair Value Option to eliminate an "accounting mismatch" (where assets and liabilities are measured on different bases, causing inconsistent profit reporting).
Subsequent Measurement of Financial Liabilities
Financial liabilities follow a simpler path. Generally, they are measured at Amortised Cost. However, liabilities held for trading must be measured at FVTPL.
Exam Tip: Remember that for financial liabilities, the "Fair Value Option" can be applied to reduce accounting mismatches, similar to how it is used for assets.
Deep Dive: Compound Instruments and Impairment
Calculating Compound Instruments
When dealing with a compound instrument, you cannot simply record the whole amount as debt or equity. You must split them. The standard procedure is to:
- Calculate the Liability Component first by discounting the future contractual cash flows (interest and principal) at the current market interest rate for a similar, non-convertible instrument.
- Calculate the Equity Component as the residual amount:
Equity=Total Proceeds−Present Value of Liability
Worked Example: Golf City (Pty) Ltd
Golf City issued R200,000 worth of debentures. The liability involves annual interest and a R100,000 cash redemption. The market rate is 12%.
- Step 1 (Liability): The PV of future cash flows discounted at 12% is R109,112.
- Step 2 (Equity):
R200,000 (Total)−R109,112 (Liability)=R90,888 (Equity)
Note that while the liability is subsequently measured at amortised cost using the effective interest rate, the equity component remains constant and is not re-measured.
Impairment and Expected Credit Losses (ECL)
IFRS 9 moved away from the old "incurred loss" model to a more proactive Expected Credit Loss (ECL) model. Instead of waiting for a default to occur, entities must recognize a loss allowance based on anticipated future losses.
The amount of the allowance depends on the credit risk profile:
- 12-month ECL: For instruments where credit risk has not increased significantly.
- Lifetime ECL: For instruments where credit risk has increased significantly since initial recognition.
Derecognition
Finally, an entity must know when to remove an instrument from its books. A financial liability is derecognised only when the contractual obligation is discharged, cancelled, or expired.
