Convertible loan notes

This helpsheet has been issued by ICAEW’s Technical Advisory Service to help ICAEW members to understand the accounting for a convertible loan note under FRS 102 and the relevant considerations for such instruments under company law.

Members may also wish to refer to the following related helpsheets:

• Preference Shares – Equity or Liability under FRS 102
• Amortised cost calculator

Convertible loan notes are one form of convertible debt. Convertible loan notes will generally have options embedded within their terms that give one or both parties to the loan notes the right or option to convert the loan notes to equity of the issuing entity, rather than for them to be settled in cash. The issuing entity will therefore ultimately either settle the loan notes in cash, by the issue of shares or a combination of the two.

These characteristics mean that while convertible loan notes are financial instruments; their classification must be determined. An instrument that does not convert to a fixed number of shares at a fixed price would be classified wholly as a liability. For instruments that have both liability and equity components (ie there is optional or mandatory conversion to a fixed number of shares at a fixed price) the accounting under FRS 102 seeks to reflect these two components.

Other forms of convertible debt and similar compound financial instruments exist, but this helpsheet will refer to convertible loan notes. Similar considerations to those outlined within this helpsheet are likely to apply to other compound financial instruments, but as always, the terms of the instrument should be fully understood and the accounting implications considered on a case-by-case basis.

The following guidance addresses the requirements and application of FRS 102 for a convertible loan note with both equity and liability components. Appendix 1 and Appendix 2 to this helpsheet include worked examples that members may find helpful to refer to.

On issue:

FRS 102 Section 22 Liabilities and Equity address the accounting on issue of convertible loan notes.

Paragraph 22.13 states that on the issue of convertible loan notes, the entity shall allocate the proceeds of issue between the liability component and the equity component. To do this, the entity takes a two step approach:

Step 1: Determine the amount of the liability component as the fair value of a similar liability that does not have a conversion feature or similar associated equity component.
Step 2: Allocate the residual amount of the convertible loan notes to the equity component.

This can be summarised as follows:

Proceeds on issue of convertible debt – Fair value of liability component = Equity component

Transaction costs:

Transaction costs must be allocated between the liability and equity component on the basis of their relative fair values. (FRS102.22.13).

Transaction costs are defined as incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability, or the issue or reacquisition of an entity’s own equity instrument. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of a financial asset or financial liability, or issued or reacquired its own equity instrument.

The transaction costs attributable to the liability component should be included in the opening value of the liability for the purposes of calculating the amortised cost under the effective interest method (assuming that the instrument is accounted for as basic under Section 11). A worked example of this can be seen on page 16 of UK GAAP Factsheet ‘FRS 102 Financial Instruments – Overview’. The transaction costs attributable to the equity component will be deducted directly from the value of the equity component.

At subsequent reporting dates:

It is important to note that per 22.14, the allocation between the liability component and the equity component calculated at the issue date is not revisited at each year end.

Instead, the liability component is accounted for in accordance with either Section 11 Basic Financial Instruments or Section 12 Other Financial Instruments of FRS 102, depending on whether the liability component is basic or non-basic.

Financial instruments measured under Section 11 using the amortised cost and effective interest method will incur an interest cost each year to ‘unwind’ the discounting applied to ascertain the instruments fair value at inception. Financial instruments measured under Section 12 will be measured at fair value with any changes in fair value taken through profit or loss.

The amount attributable to the equity component does not change from the amount that was allocated at inception.

At exercise – Conversion option taken:

The liability component is derecognised. The equity component that was recognised at inception remains in equity, but may be transferred to a different category of equity – for example from ‘other reserves’ to share capital/share premium (please see Company Law Considerations).

If the convertible loan notes are converted to shares in accordance with their original terms and conditions, then no gain or loss is recognised in profit or loss. This is in accordance with s22.8A.

At exercise - Cash settlement option taken:

The liability component is derecognised. Per s11.38 any difference between the carrying amount of the financial liability extinguished and the consideration paid is recognised in profit or loss.

The equity component remains in equity but may be transferred to a different category of equity – for example from ‘other reserves’ to retained earnings. This transfer is simply the reverse of the interest charged to profit or loss which would not have been regarded, under company law, as a realised loss and so the reversal here would also not be considered a realised profit, the effect on distributable reserves should therefore be £nil (Technical Release 02/17BL para 6.59 – 6.60).

At exercise - Conversion option taken:

Companies Act 2006 Section 610(1) states that if a company issues shares at a premium, whether it be for cash or otherwise, a sum equal to the aggregate amount or value of the premium on those shares must be transferred to an account called “the share premium account”.

In the case of a convertible loan note, the consideration referred to in Section 610 is the forgiveness of the full nominal value of the liability. This may well be different to the carrying amount of the liability under FRS 102 which may reflect issue costs and discounting as well as the initial split between debt and equity.

This means that to ensure the share premium account complies with the requirement of Section 610 it will often be necessary to make a further adjustment on the conversion of convertible loan notes to ensure that the share premium reflects the difference between the full nominal value of the liability that has been released and the nominal value of shares issued, rather than the difference between the liability derecognised from the financial statements and the nominal value of shares issued.

An example of this adjustment can be seen in the worked example in Appendix 2.

ICAEW members, affiliates, ICAEW students and staff in eligible firms with member firm access can discuss their specific situation with the Technical Advisory Service on +44 (0)1908 248 250 or via webchat.

ABC Limited issues 1,000 convertible loan notes on 1 Jan 20X5. The convertible loan notes have a term of 3 years and were issued at par with a face value of £500 per note. Interest is payable annually in arrears at 5% per convertible loan note.

The holder can convert the loan notes to equity on the 3rd anniversary of the issue of the convertible loan notes, at a conversion of 10 £1 Ordinary Shares per note.

If a 3 year fixed term loan had been taken out for the same amount without any conversion option, the market rate of interest would have been 8%.

ABC Limited has a year end of 31 December.

On issue:

Allocation between liability and equity components must be calculated as the conversion meets the fixed for fixed condition.

(As a reminder: Proceeds on issue of convertible debt – Fair value of liability component = Equity component)

Proceeds on issue = 1,000 x £500 = £500,000

Fair value of liability component = Present value of similar market rate debt instrument with no conversion feature:

Present value of principal = £500,000/(1.08)^3 = £396,916
Present value of interest = (£25,000/0.08) x (1-(1/1.08)^3) = £64,427

Present value of principal plus interest = £396,916 + £64,427 = £461,343

Equity component therefore = £500,000 - £461,343 = £38,657

Therefore at inception:

Dr Cash £500,000
Cr Liability £461,343
Cr Equity (other reserves) £38,657

Subsequent reporting dates:

The interest cost and allocation to the financial liability are calculated as follows:

Year ended 31 December 20X5:

Dr Interest cost £36,907
Cr Financial liability £11,907
Cr Cash £25,000

Being the payment of interest for 20X5 and the unwinding of the discount applied

Year ended 31 December 20X6:

Dr Interest cost £37,860
Cr Financial liability £12,860
Cr Cash £25,000

Being the payment of interest for 20X6 and the unwinding of the discount applied

Year ended 31 December 20X7:

Dr Interest cost £38,890
Cr Financial liability £13,890
Cr Cash £25,000

Being the payment of interest for 20X7 and the unwinding of the discount applied

On exercise:

At 1 January 20X8 assuming conversion into shares:

Dr Financial Liability £500,000
Cr Share Capital £10,000
Cr Share premium £490,000

Being the issue of 1,000 * 10 £1 shares

Dr Equity (Other Reserves) £38,657
Cr Equity (P+L Reserves) £38,657

Being optional transfer of equity component to P+L reserves.

OR

At 1 January 20X8 assuming settled in cash:

Dr Financial Liability £500,000
Cr Cash £500,000

Being settlement of liability for cash.

Dr Equity (Other Reserves) £38,657
Cr Equity (P+L Reserves) £38,657

Being optional transfer of equity component to P+L reserves.

Summary:

Conversion into shares:

 * The credit in respect of this amount will be £25,000 to cash in year ended X5, X6 and X7, representing the 5% interest paid on the loan notes.

Settled in cash:

This example has the same fact pattern as Appendix 1 other than it can be settled in cash or converted at any point over the 3 years, rather than just at the 3 year anniversary.

In this example, the option is taken to redeem the convertible loan note on the 2nd anniversary of their issue, 1 Jan 20X7:

On issue – as per Appendix 1

Year 1 and Year 2 – as per Appendix 1

On exercise:

At 1 January 20X7 assuming conversion into shares:
Dr Financial Liability £486,110 Cr Share Capital £10,000 Cr Share premium £476,110

Being the issue of 1000 * 10 £1 shares reflecting the forgiveness of the carrying amount of the liability component.

Dr Equity (Other Reserves) £38,657 Cr Share premium £13,890 Cr Equity (P+L Reserves) £24,767

Being recognition of total share premium of £490,000 being the difference between the nominal value of shares issued and the total consideration of the release from a liability with a nominal value of £500,000.

OR

Cash settlement taken at 1 Jan 20X7:

Dr Financial Liability £486,110 Dr Loss on Settlement (P+L) £13,890 Cr Cash £500,000

Being settlement of liability for cash.
Dr Equity (Other Reserves) £38,657 Cr Equity (P+L Reserves) £38,657

Being optional transfer of equity component to P+L reserves.

Summary:

Conversion into shares:

* The credit in respect of this amount will be £25,000 to cash in year ended X5 and X6, representing the 5% interest paid on the loan notes.

Settled in cash: