Hong Kong: Impact Of HKFRS On Investment Structuring

New Accounting Standards Are Creating Deal Structuring Issues For Private Equity
Last Updated: 9 May 2007
Article by Paul Walters and Ian Farrar

Historically Straightforward…

Accounting for investments in a fund’s financial statements has historically been relatively straightforward – almost always at fair value. While difficulties arise when attempting to arrive at a reliable and supportable fair value on a consistent basis, the concept of fair value for non-listed securities has been largely accepted by the industry and its investors. However, the implementation of "IFRS equivalent" standards, and hence the adoption of IAS 32 and 39 into several of the region’s accounting frameworks (such as those in Hong Kong, Singapore and Australia), has brought to the surface other accounting issues with very different and problematic operational implications for the industry.

One of these issues – the accounting for certain convertible bonds – is not restricted to the funds industry, but is prevalent in many sectors including in entities operating in China that are seeking private equity finance in the run-up to an IPO. Private equity funds frequently attempt to structure financing transactions so as to limit the downside risk associated with an equity stake in an IPO candidate. This has often been achieved through the use of convertible instruments that provide both a guaranteed return of capital and the opportunity to benefit from upside potential in the value of the investee.

From an accounting perspective, convertible instruments typically combine the characteristics of an equity component, to be able to gain from an increase in value of a portfolio company post-listing, and a host debt instrument, that requires the portfolio company to redeem the instrument for cash under certain circumstances. Under previous accounting standards, the conversion option embedded in a convertible instrument was ignored in the financial statements of the issuer, often leading to a reduced interest expense and no requirement to remeasure the instrument.

…but new standards can lead to volatility

As has been seen during the recent financial reporting season, however, the implementation of IAS 32 and 39 has brought some unpleasant surprises for companies that had not fully anticipated their implications regarding the accounting for convertible instruments. A number of companies have seen significant volatility in reported net profits due to the recognition in the income statement of fair value gains and losses on the embedded conversion option. Naturally, this potential impact on net profit is a concern for management, and has caused companies to avoid, or at least give careful consideration to, using convertible bonds as a way of raising capital, hence having an impact on the private equity industry trying to structure deals.

When assessing if there will be an impact to a company’s bottom-line profit, management needs to delve into specific contractual terms, and match them to the guidance provided by applicable accounting standards. (IAS 32 classifies financial instruments based upon the substance of the contractual arrangement; contractual terms play a greater role than economic substance.) It is therefore crucial that a company’s management and prospective investors assess the requirements of standards when negotiating the structure of a new issuance of securities, and in doing so ensure that any impact on the issuer’s net profit can be avoided.

The details

While the host debt contract typically will be classified as a financial liability in the books of the issuer to the extent that there are contractual cash outflows in respect of repayment of principal or interest, the embedded option needs to be analysed separately to see if it is a derivative that needs to be fair valued through profit or loss. From a high-level perspective, issuers must ensure that conversion options embedded in the host "vanilla bond" contract qualify as "equity instruments" rather than "financial liabilities" to avoid remeasurement gains and losses being recognised in profit or loss. To determine the accounting for a particular deal structure, one has to look at the specific requirements of the standards in their entirety. However, some of the key considerations that can catch out an unsuspecting issuer are set out below.

  • A contractual obligation to deliver cash gives rise to a financial liability (IAS 32.11). Often a debt instrument incorporates a requirement to make principal and interest payments, and is therefore classified as a financial liability. The host contract in a convertible bond typically will be classified as a financial liability as a result of this criterion.
  • IAS 32.16(b) requires that a derivative instrument that will or may be settled in the issuer’s own equity instruments is itself an equity instrument only if the issuer must exchange a fixed amount of cash (or another financial asset) for a fixed number of its own equity instruments. An embedded conversion feature will therefore be classified as an equity instrument if, inter alia, the terms result in a fixed amount of cash for a fixed number of shares. If the terms are not "fixed-for-fixed", the conversion feature is likely to be an embedded derivative that needs to be separate and remeasured to fair value at each period end.
  • A conversion feature also fails to be accounted for as a derivative if it may be settled net rather than through the exchange of shares for cash.
  • A convertible bond ("CB") issued in a currency other than the functional currency of the entity fails the fixed-for-fixed test as a fixed amount of the foreign currency represents a variable amount of the functional currency – this conclusion was confirmed by both IFRIC and the IASB in 2005.
  • A CB that incorporates a strike price that changes depending upon the period of exercise represents a variable amount of cash for a fixed number of shares and so fails the definition of equity.
  • A CB with an option for the issuer to redeem at fair value does not contain an equity component, as this is a form of net settlement of the conversion option.

Examples of applications in practice

As can be seen, the application of the principles in IAS 32 can be complex, and care needs to be taken when determining these terms. To see the practical implication issues of the above principles, let’s look at a few scenarios to illustrate the points, and determine whether the structuring impacts the issuer’s profit or loss.

1. Scenario

XYZ Holdings Limited, which has a € functional currency, issues the following bond:

  • notional amount of €100 million
  • 4% fixed rate
  • 1/1/2x01 - 31/12/2x10
  • Convertible into ordinary shares of the entity, at a ratio of 10 shares per €1,000 convertible at the holder’s discretion during the term.

Accounting

This is a compound instrument (IAS 32.29). From the perspective of the entity, such an instrument comprises two components: a financial liability (a contractual obligation to pay cash for the interest and redemption amount, if the holder does not covert); and an equity instrument (a call option granting the holder the right to convert a fixed amount of his debt into a fixed number of shares).

There would be no impact on profit or loss due to changes in the fair value of the embedded conversion rights.

2. Scenario

XYZ Holdings Limited, which has a € functional currency, issues the following bond:

  • $100 million

  • 3% fixed rate
  • 1/1/2x01 - 31/12/2x10
  • Convertible into ordinary shares of the entity, at a ratio of 10 shares per $1,000 convertible at the holder’s discretion.

Accounting

This instrument is a liability in its entirety. From the perspective of the entity, such an instrument comprises two components: a host contract that is a financial liability and an embedded derivative (a call option granting the holder the right to convert a variable amount of debt into a fixed number of shares, as $100 million measured in the entity’s functional currency, euros, is a variable amount of cash).

A change in the fair value of the embedded conversion option would be recognised in profit or loss for the period.

3. Scenario

XYZ Holdings Limited, which has a £ functional currency, issues the following bond:

  • £50 million
  • 5% fixed rate
  • 1/1/2x01 - 31/12/2x10
  • Convertible into ordinary shares of the entity, at a ratio of 10 shares per £1,000 convertible at the holder’s discretion during the term
  • The issuer has the option to repurchase the instrument at fair value.

Accounting

This instrument is a liability in its entirety. It comprises a host contract that is a liability and a conversion option that the issuer has the ability to settle in cash (via repurchase at fair value). The conversion option is a derivative that one party can choose to settle net in cash; it is therefore a financial liability or asset in accordance with IAS 32.26.

A change in the fair value of the embedded conversion option would be recognised in profit or loss for the period.

4. Scenario

XYZ Holdings Limited, which has a £ functional currency, issues the following perpetual debt:

  • €250 million
  • Variable rate Libor + 120 bp interest, if management declares a dividend on ordinary shares
  • The issuer has an option to convert the instrument into a fixed number of shares at any time after five years from issuance

Accounting

The instrument is equity in its entirety. The issuer has an unconditional right to avoid cash payments (by not declaring dividends on ordinary shares) and the conversion ratio is fixed-for-fixed.

There would be no impact on profit or loss due to changes in the fair value of the perpetual debt. Dividends on the instrument would be treated as a distribution from equity.

Summary

In conclusion, the area of convertible bonds is a complex one and the wrong choice of instrument can have an adverse effect on reported results. Consequently, it is crucial to consider the accounting for such instruments when deal structures are being drawn up; finalising the deal before assessing the accounting requirements has, for some companies, led to a nasty surprise.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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