The accounting for share-based transactions with a choice of settlement depends upon which party has the choice.
a. The entity has the choice
The accounting treatment is determined by whether there is an obligation to deliver cash:
- Obligation to deliver cash => treat as cash settled
- No obligation to deliver cash => treat as equity settled
b. Third party choice (most likely at TAC)
In this case, the transaction is treated as a compound instrument. A compound instrument is a financial instrument that has characteristics of both equity and liabilities, for example a convertible bond.
IAS 32 (also applies to FRS102) requires compound instruments to use split accounting at the date of issue into a liability and equity component.
Liability: calculate the present value of future cash flows using interest rate of equivalent bond with no conversion option as the discount rate
Equity (option to convert into shares): Simply the total value of the bond, less the liability element above
The two parts must be presented separately in the financial statements and going forward, the liability element held under amortised cost per IAS 39.
The method of splitting the financial instrument between equity and liabilities is:
a. Calculate the present value of the debt element discounting at the market rate of interest
b. Deduct the present value of the debt from the proceeds of the issue, the difference is the equity element
c. On the balance sheet, show the debt element and the equity element separately
The double entries to record the transaction initially are:
Each year, you un-wind the discount on the liability and recognise as a finance cost in the P&L at the market rate:
Debit finance cost
I have attached an example that you can follow to ensure you're treating these convertible loans correctly. Note that contracts will vary depending on the number of shares issued and at what price. Please come and speak to me if you'd like to walk through an example. I would advise using the attached working paper as a template for calculating your double entries.
Let me know if you have any questions!