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Synthetic convertibles and their journey to IFRS financial statements

Synthetic convertibles

There are still some issues that need to be resolved with respect to the recognition of synthetic convertibles.

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While traditional convertible bonds are familiar instruments used by companies as part of their financing strategy and their accounting treatment is sufficiently known, there still are some issues that need to be resolved with respect to the recognition of synthetic convertibles.

In the case of synthetic convertibles, the entitlements of investors arising from conversion options are provided not through issue of equity instruments but in the form of a cash settlement. Some of the advantages of this type of conversion option are fewer legal restrictions with regard to documentation requirements and the protection of existing shareholders from dilution, thus making it no longer necessary in many cases to obtain approval at the annual general meeting for issue of such instruments. Apart from legal aspects, actual price advantages are also observable in the market for embedded conversion options. Compared to over-the-counter share options with identical features, price differences of between 0.4% and 0.75% can be observed.

How are synthetic convertibles recognised in a company's IFRS financial statements?

Firstly, as it is settled in cash, the synthetic convertible (including the conversion option) qualifies as a financial liability as defined in IAS 32.11. Secondly, it is established that the conversion option meets the criteria of a derivative as defined in IAS 39.9 and is to be classified as an embedded derivative pursuant to IAS 39.10. Taking into account IAS 39. AG30, it is determined that the conversion option is not closely related to the host contract and that it has to be accounted for separately from the host contract. It is initially separated from the host contract in other comprehensive income.

In order to avoid exposure to future fluctuations in fair value of the embedded derivative in profit or loss, companies usually conclude so-called 'mirror calls' with identical features to the conversion option for treasury shares including 'cash settlement'. Due to their 'cash settlement', these 'mirror calls' represent stand-alone derivatives in the IFRS financial statements and almost completely offset fluctuations in fair value of the embedded derivative of the synthetic convertible in profit or loss. Complete offsetting can usually not be achieved, as the embedded derivative and the concluded 'mirror call' are exposed to different credit risk. The credit risk adjustment entries for the two derivatives therefore do not offset each other completely.

The success of the hedging strategy depends on the cash settlement of mirror calls. If 'physical settlement' is agreed, on the other hand, the convertible does not qualify as a derivative pursuant to IAS 39, but as an equity instrument according to IAS 32, with no offsetting effect in profit or loss. The purchase of treasury shares in the short term followed by immediate sale can also have the consequence that the desired offsetting effect in profit or loss is not achieved.

In summary, synthetic convertibles definitely provide an interesting alternative to traditional convertible bonds used as part of a company's financing strategy. Sound understanding of the possibilities to arrange parameters, hedging and the associated accounting implications is key.

Source: KPMG Corporate Treasury News, Edition 61, November 2016
Author: Ralph Schilling, Senior Manager, Finance Advisory, rschilling@kpmg.com 

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