Financial Assets - Convertible loan 7 / 12

Compound instruments (Convertible loans)

Be careful here as these are treated differently according to whether they are receivable loans (assets) or payable loans (liabilities)

This is because, if you remember, the amortised cost category for financial assets has 2 tests, whereas the amortised cost category for liabilities does not have any

The 2 tests for placing a financial asset into the amortised cost category are:

  1. Business model - do we intend to keep (not sell) the loan

    ... presumably we do hold until the end and not sell it - so yes that test is passed

  2. Cashflow test - Are the cash receipts capital and interest only?

    No - There is the potential issue of shares that we may ask for instead of the capital back.

For a receivable convertible loan - it fails the cashflow test - as one receipt may be shares and not just capital and interest

Therefore a receivable convertible loan cannot be amortised cost and so is a FVTPL item

However, there are no such tests for liabilities, and so a payable convertible loan is not held for trading and so falls into the amortised cost category

TypeCategory
Receivable Convertible LoanFVTPL
Payable Convertible LoanAmortised Cost

Accounting Treatment of above categories summary

InitialYear End
FVTPLFVFV
Amortised CostFVAmortised Cost

An Example:

2% Convertible Loan €1,000

You are also told the non-convertible interest rates are as follows:

Start: 5%
End of year 1: 6%
End of year 2: 7%
End of year 3: 8%

  • As in the payable we need to calculate FV initially. 

    We did this and it came to 892.

  • Then we perform amortised cost BUT also adjust to FV each year end as this a FVTPL item. 

    Here’s a reminder of what we had before (but with a new FV adj column added....

OpeningInterestPaymentFV adjClosing
89245-20917
91746-20943
94348-20971
97149-201,000

So we need to change the closing figures (and hence opening next year) to the new FV at each year end.

Calculating the FV of a loan is the same as before..

  • Step 1: Take all the CASH payments (capital and interest)

  • Step 2: Discount them down at the MARKET rate

  • FV at end of year 1
    Capital discounted = 1,000 / 1.06^3 (3 years away only now) = 840
    Interest = 20pa for 3 years @ 6% = 20 x 2.673 = 53
    Total = 893

  • FV at end of year 2
    Capital discounted = 1,000 / 1.07^2 (2 years away only now) = 873
    Interest = 20pa for 2 years @ 7% = 20 x 1.808 = 36
    Total = 909

  • FV at end of year 3
    Capital discounted = 1,000 / 1.08 (1 year away only now) = 926
    Interest = 20pa for 1 year @ 8% = 20 x 0.926 = 19
    Total = 945

So the table now becomes...

OpeningInterestPaymentFV adjClosing
89245-20-24893
89346-20-10909
90948-20+8945
94549-20+261,000

Remember interest goes to the income statement as does the FV adjustment also

The closing figure is the SFP receivable loan amount

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